rfr · H30WRFR7 · 2016-01-19 00:00:00 — Given their central importance for the conduct of monetary policy, we review below the Riksbank’s international forecasts and its inflation forecasts both against actual outcomes and by comparing the Riksbank’s forecast errors to those of other forecasters. We also report on the Riksbank’s forecasts for GDP and unemployment. And we conclude with some observations on the Riksbank’s forecasting performance based in part on our narrative of the evolution of monetary policy during 2010-2015. 6.1 The Riksbank’s International Forecasts A recent study by Aranki and Reslow evaluates the Riksbank’s forecasts for GDP growth, inflation, and policy rates abroad.7 The analysis employed tradeweights to take account of the relative importance of various countries for the Swedish economy. Until the end of 2012, the Riksbank employed “the total competitiveness weights” (TCW) produced by the IMF. Towards the end of 2012, the Riksbank switched to using the KIX (“krona index”) designed by with weights that take better account of the importance of emerging market economies. Figure 10 shows the weighted Riksbank forecasts of foreign GDP growth, inflation, and policy rates from 2005-2015. Most striking is the Riksbank’s consistent overestimation of the future path of policy rates abroad from 2009. With regard to GDP growth abroad, the Riksbank’s forecasts were not all onesided, but the Riksbank tended to overestimate GDP growth abroad more often than not. The Riksbank underestimated the collapse of global GDP growth in 2008-09 and then underestimated the strong international recovery in 2010, 6 ANALYSIS OF THE RIKSBANK'S FORECASTING PERFORMANCE but it missed the protracted slowdown in global GDP growth in 2011 and 2012, led in large part by the weak performance of the euro area. The Riksbank’s weighted international inflation forecasts were no better. The Riksbank first underestimated global inflation during the boom in 2007-08 and underestimated the sharp global disinflation during the collapse in 2009. Riksbank forecasts of global inflation then fell short consistently from 2010 until late 2012; and then the Riksbank failed to foresee the 2 percentage point decline in inflation abroad from early 2013 to 2015. This was a highly volatile period for the global economy, with the severe financial crisis and collapse of 2007-09, the strong global recovery, then the surprisingly disinflationary sluggishness, and the long period during which policy rates in the developed world remained at the zero lower bound. Generally speaking, the Riksbank was not alone in the forecast mistakes it made about the global economy. Few other analysts forecast KIX-weighted global variables. However, a great many analysts publish forecasts for the euro area and the . Aranki and Reslow compute a KIX-2 index, consisting of just the euro area and the to compare this index of “international” GDP growth and inflation forecasts of the Riksbank with those of other forecasters. They report that the euro area’s weight is about 49 per cent of the original KIX index and the US weight about 9 percent; so the KIX-2 index captures 60 per cent of the broader KIX index that the Riksbank usually uses to forecast international developments. Figure 11 compares the accuracy and bias in forecasts of GDP growth and inflation for the KIX-2 weighted “international” index by the Riksbank to comparable forecasts of 12 and 8 forecasting institutions, respectively, including the () and the Organization for Economic Cooperation and Development ().8 As Aranki and Reslow explain, the mean error in the figure, or bias as it is known, describes the systematic overestimation or underestimation of a forecast, if any. This is computed as the mean value of the outcomes minus the forecasts during the whole evaluation period. For instance, a negative mean error indicates that the forecasts have on average overestimated the outcomes and a positive mean error indicates forecasts have underestimated outcomes. But the mean error can be a poor measure of accuracy because large positive and negative forecast errors can offset each other on average over the evaluation period. The mean absolute forecast error reported in the figure, computed as the average of the absolute value of the forecast errors, measures the accuracy of the forecasts. The dashed line in the chart, the variable’s own standard deviation over the evaluation period, is a kind of benchmark against which to judge forecast accuracy. It shows the accuracy of simply using the mean to forecast the variable over the whole evaluation period. Figure 11 shows relatively small differences in accuracy among the different institutional forecasters. The Riksbank’s accuracy, for both GDP and inflation, is close to the average for all forecasters. The IMF and the are also close the average and have about as good 6 ANALYSIS OF THE RIKSBANK'S FORECASTING PERFORMANCE accuracy as the Riksbank; although judged against the benchmark no fore- caster does particular well. The tendency for the Riksbank to over-predict GDP growth is reflected in the negative mean forecast error in the figure. But every other institution also over-predicted GDP growth on average during the period, some more so and some less so than the Riksbank. With regard to inflation, the Riksbank’s mean forecast error is small, and no clear bias is evident among the various institu- tions in predicting inflation. Forecast accuracy for inflation is about the same for all the forecasters in the chart, though again judged against the benchmark, the inflation forecasts are not particularly good. On balance, the Riksbank’s ability to make forecasts of the international economy is close to average for both GDP growth and inflation. 6.2 Riksbank Forecasts of Inflation, GDP Growth, and Unemployment in The Riksbank's deliberations on inflation focus primarily on the CPIF consumer price index with a fixed mortgage rate. Figure 12 shows CPIF inflation together with two other often discussed measures of inflation – overall CPI inflation and CPIF inflation excluding energy. The volatility of CPI inflation is due to its sensitivity to interest rates and the Riksbank's repo-rate policy, which is why the Riksbank prefers to monitor inflation via the CPIF index. As can be seen from the figure, the CPIF inflation rate and the CPIF inflation rate excluding energy track each other reasonably well over time. The figure shows that inflation as measured by the CPIF consumer price index was close to the 2 per cent inflation target in 2010. Inflation then fell below the target in 2011, dropped to 1 per cent in 2012 and 2013, and fell to around in 2014. Figure 13 from an article by shows CPIF inflation together with various short-term inflation forecasts one to three months ahead – the Riksbank’s inflation forecasts, the mean of the projections of other forecasters, and the difference between the lowest and highest projections of other forecasters.9 Few inflation outcomes ended up outside of the shaded area in 2011 and 2012. But in 2013 and 2014, CPIF inflation came in below the Riksbank’s forecasts and those of everyone else on four occasions – , October 2013, 2014, and . Not only did inflation become more difficult to predict, but it was also apt to be over-predicted, too, and not only by the Riksbank. Table 3 compares short-term Riksbank CPIF forecasts for horizons of one to three months to projections of 16 other forecasters from January 2013 to 2015, the period that includes the surprisingly sharp drop in inflation. As pointed out by Löf, of those institutions that issued forecasts for most months in the evaluation period, the major banks fared the best. They had a lower root mean squared error (RMSE) than the Riksbank, and the Riksbank’s CPIF forecasts were biased upward.10 That said, the Riksbank was at 6 ANALYSIS OF THE RIKSBANK'S FORECASTING PERFORMANCE a disadvantage because it did not release a new inflation forecast every month and so had a longer forecast horizon than others in many cases. Longer-term forecasts for inflation are assessed in the annual Account of Monetary Policy produced by the Riksbank. Figure 14 follows Riksbank forecasts for CPIF inflation in 2012 from January 2011 to the end of 2012 and shows comparable forecasts by other institutions over the same period. The Riksbank’s forecasts lie in the middle of the range of all forecasts as they advance from early 2011 to late 2012, and as they fall from the 1.75 per cent range to 1 percent. Likewise, Figure 15 follows Riksbank forecasts and those of other forecasters for CPIF inflation in 2014, from January 2013 to the end of 2014. Again, the Riksbank’s forecasts lie in line with the forecasts of others as all the forecasts are gradually revised downward from around 1.4 per cent in early 2013 to 0.5 per cent in 2014. On the whole, we see that these longer-term Riksbank forecast revisions were in line with those of other analysts as inflation unexpectedly drifted downwards. Most forecasts were close to one another and revised in a similar . There is some spread, especially early on, but none of the forecasters appears to foresee the outcome better than the others. Turning again to the Account of Monetary Policy 2014, we compare the bias and accuracy of Riksbank forecasts to those of other institutions---for CPIF inflation, GDP growth, and unemployment in Figures 16 through 18. All forecasters systematically overestimated CPIF inflation, GDP growth, and unemployment during the period 2007-2014. The Riksbank was among the least biased forecasters of unemployment, it had a slightly worse bias than average forecasting GDP growth, and surprisingly it was among the most biased forecasters of CPIF inflation. The accuracy for each forecaster in these figures is reported as a deviation from the mean value calculated for all the forecasters. So a negative value for an institution indicates that its forecast is better than the average forecaster and a positive value indicates that it is worse. For the most part, difference in forecast accuracy is relatively small among the institutions. That said, the Riksbank had the most accurate forecast of GDP growth, nearly the most accurate forecast of CPIF inflation, and was a slightly above average forecaster of unemployment. All in all, the Riksbank can be said to have made good forecasts, relative to other forecasters, of GDP growth, unemployment, and CPIF inflation in . 6.3 Concluding Observations on the Riksbank’s Forecasting Performance It is not sensible to blame the central bank for unforeseeable changes of circumstances; but the central bank has some responsibility for making judgements about likely developments both at home and abroad. The two areas where forecasts went wrong seem to be: (1) being far too optimistic about the 6 ANALYSIS OF THE RIKSBANK'S FORECASTING PERFORMANCE euro area from the spring of 2010 onwards when it became clear that there were serious problems with the monetary union; (2) using a far from obvious assumption about interest rates overseas, which was markedly out of line with implied market rates, and which had significant implications for the forecast judgements about the exchange rate of the krona which led to an over estimate of the likely inflation rate. These two issues were raised repeatedly at the monetary policy meetings, mainly as objections to the majority’s policy posi- tion, but with evident debate. Was there adequate discussion of these two issues by at earlier pre-meetings in the policy-making From the available documents it is hard to tell. In any case, one of the problems with the present forecast process is that those two issues should have received much greater prominence in the Minutes of the relevant policy meeting because they were absolutely central to the forecast and policy deci- What we saw instead in the Minutes was an extensive discussion of models in producing the forecast – they seemed to set the agenda rather than a discus- sion of the big issues, such as the slowdown in Europe, facing the Board. models used by the Riksbank have the property that inflation always tends to to the target. But during the period under review it didn’t. ence teaches the danger of relying too heavily on models to the exclusion of The models had rather to say about rising house prices and household There was no discussion of the economics of falling real interest rates across the world, the fact that could not stand out from this, and the consequences for rising house prices in . Again, the models had nothing to say about these questions. One of the problems with the monetary policy discussion was that the majority apparently went along with the overly optimistic inflation forecasts that the model produced in the main scenarios because it suited their to raise interest rates to counter the potential con- sequences of rising house prices and household indebtedness, even if they hadn’t much faith in the inflation forecast when making their judgement about the repo rate. If so, they went along with a forecast which did not really rep- resent their own views. They should either have clarified that they were pur- suing an objective other than meeting a target for inflation, or pressed more strongly for a different forecast to be published. It is important that the forecast process allow sufficient time for members of the Board to raise major questions about the approach underlying the staff In particular, judgements about the likely outturns in the rest of the world should not simply be taken as a technical issue for staff to resolve. needs to be a more systematic process for assessing and responding to forecast “errors,” in which the process is not one of apportioning blame but of learning from the outturns so that future forecasts can be adapted to the lessons. also needs to be sufficient time at Board meetings to discuss the major assump- tions underlying the forecast. 6 ANALYSIS OF THE RIKSBANK'S FORECASTING PERFORMANCE One of the unfortunate features of the focus on models when constructing the forecast is that relatively small changes in the assumed future path for the policy rate had an impact on the forecast inflation rate that was significant for the choice of the current repo rate. So seemingly arcane debates about whether the expected policy rate three years ahead was 50 basis points too high or low mattered for the immediate policy decision. That took time away from more important discussions about the forecast. 7 Evaluation of Monetary Policy in The combination of an independent Riksbank and its pursuit of an inflation target has served well. No country could pretend to avoid the consequences of the global financial crisis, and none did. Nevertheless, monetary policy in proved to be highly controversial in recent years. Why was this the case? the differences of view within sufficiently far apart to justify the tensions evident among its members? Since the start of our Review period in February 2010, monetary policy in has come full circle – from a repo rate of close to zero, rates were gradually raised as recovery took hold, and then were cut again as recovery disappointed until today the repo rate is actually negative. Our evaluation of this journey and the monetary policy conducted by the Riksbank from 2010 onwards leads to six main conclusions: First, the response of the Riksbank to the rapid recovery of the Swedish economy from the global financial crisis – which entailed raising official interest rates from to between 2010 and 2011 – was broadly accepted by all members of , and appears not unreasonable in the light of all the information available to the Riksbank at the time. Nevertheless, the need to accommodate the consequences for domestic prices of the sharp fall in the exchange rate could have justified a temporary overshooting of the inflation target (see Chapter 8). Some of the critical public commentary subsequent to this episode is wide of the mark. Although the downturn of the Swedish economy in 2008-09 was similar to that in other industrialised countries, the rebound in the Swedish economy, particularly marked in exports, was more rapid than elsewhere and led to a shared view that it was justified to begin the process of raising rates. It was quite sensible to start raising rates from their extraordinarily low level adopted during the crisis. Moreover, although there were differences of judgement on the Board – and it would in the circumstances have been very surprising if there had not been – those differences were small. The dissenters on never voted for a level of the current repo rate more than one quarter of a percentage point below that actually set by the majority, and even the most extreme dissenter, , having voted for a repo rate of in , was voting one year later for a repo rate of and then a few months after that for a rate of . During 2010 and 2011, monetary policy was, therefore, responding to evidence of a recovery and was being set in what might be described as a normal fashion in terms of the outlook for inflation. The individual nature of voting on policy which characterises the Riksbank, in contrast, for example, to in the , was at its best in 2010-11. The differences of view expressed in the minutes were well within the bounds of reasonable differences of judgement about the outlook 7 EVALUATION OF MONETARY POLICY IN 2010-2015 for the economy and for inflation, and the robust discussion helped to ensure that all possibilities were considered. Since members vote for a level of the repo rate, dissenters who believe that policy is some way off track must make that clear by voting for what they believe to be the appropriate rate. A vote for a slightly lower rate than that adopted by the majority cannot subsequently be used as evidence that a dissenter believed that a very different repo rate was appropriate. During this period, the minutes contain rather expression of concern about household indebtedness and house prices which were to become so contentious later. Whether this was because those who were driven by such concerns felt it was awkward to admit them publicly, given the remit of the Riksbank to pursue the inflation target, or whether their concerns grew gradually over the period, is hard to judge. Second, the situation started to change in late 2011 and 2012. During the second part of the period covered by our Review, the Riksbank was slow to realise the extent of the problems in the euro area and, especially during 2013, the majority was slow to cut interest rates. This problem was exacerbated not only by overoptimistic judgements about economic growth in the euro area but also by assumptions about the likely paths of interest rates overseas that were significantly out of line with expectations in financial markets. The result of those assumptions was that the forecasts for future inflation were much higher than actual outturns. By 2014, these problems had become sufficiently worrying that a majority of voted, against the Governor’s wishes, for an especially aggressive cut in interest rates. From late 2011 onwards there was inadequate appreciation of the significance of the problems in the world economy, and especially in the euro area (see Chapter 6). This turned out to be the single largest source of forecast error. The construction of forecasts for the world economy made by staff inside a central bank typically, albeit understandably, gives too much weight to the forecasts of their counterparts overseas and the international organisations, both of which are likely to present a somewhat more rosy scenario for the economic outlook than is objectively justified. A central bank naturally spends more time and effort forecasting and modelling its own economy where it has a comparative advantage. To counteract this institutional bias, it is important for members of to raise the big questions about the outlook that will determine outturns in the world economy, and to challenge staff forecasts. A second problem in the shared reliance on forecasts to set policy was the agreement of the majority of Board members to the assumption that interest rates in the rest of the world would follow a path markedly above that implied by the prices of financial futures contracts. The consequence of this assumption was that the path of the krona exchange rate was weaker relative to that implied by expectations in financial markets and, as a direct result, to raise the inflation forecast. Using a path for overseas interest rates closer to that implied by market rates would have led to a lower inflation forecast, and a faster response of policy to the deteriorating situation abroad. The minority on the 7 EVALUATION OF MONETARY POLICY IN 2010-2015 Board pointed out the problem on several occasions but had impact on the methods used to produce the Riksbank forecast. Although the Riksbank is aware of the problem we therefore recommend: Recommendation: the Riksbank should re-examine its methods for producing forecasts for both the world economy and overseas interest rates to help focus on the big issues surrounding the outlook. should explain in more detail the basis for the assumptions about overseas growth and interest rates. By far the most serious problem, however, was the growing discrepancy between the future path for the repo rate forecast by the Riksbank itself and the future path implied by prices in financial markets (illustrated in Figure 9). We comment below on the practice of discussing monetary policy in terms of the path of interest rates over a three-year horizon. But what is surprising, given the emphasis placed on the path for the repo rate by the Riksbank, is how weight markets attached to the Riksbank’s forecasts of its own actions. The path published by the Riksbank was rarely, if ever, decisive in steering market rates. For example, in 2011 the Riksbank raised the repo rate and market interest rates over horizons of a year or so fell by almost 50 basis points. The Goodhart and (pp. 78-93) of Riksbank monetary policy from 2005 to 2010 also examined the extent to which the market's implicit expected repo rate path corresponded to the Riksbank's published repo rate path around the 24 monetary policy meetings from February 2007 to . For the first seven policy meetings from February 2007 through 2008, Goodhart and Rochet report that the intended repo rate path and market forward rates correspond reasonably closely with the former leading the latter, much as the Riksbank had hoped. The global financial crisis changed that pattern. The five meetings from through February 2009 saw the market path falling consistently below the intended repo rate path as if the market expected the Riksbank to ease policy more aggressively against the downturn, perhaps because the markets were more pessimistic about rising unemployment, or they thought the Riksbank would be less worried about inflation. Then for the five meetings from through the market forecast a rapid normalization of the repo rate even as the Riksbank kept its published repo rate path low. During this period, the Riksbank seemed unable to steer the market's expected future repo rates lower. As the Swedish economy bounced back strongly in 2010, the Riksbank steepened its published repo rate path for six meetings beginning in February 2010 through and began in a sequence of repo rate rises; but the market forecast a much slower normalization of the repo rate. The gap between the two paths actually widened as the published path reached at the three-year horizon endpoint but the market revised its endpoint down from to . This divergence created problems for both the majority and minority positions on the Board. For the majority, the problem was that it was advocating 7 EVALUATION OF MONETARY POLICY IN 2010-2015