Forecasting Inflation for Inflation-Targeted Countries: A Comparison of the Predictive Performance of Alternative Inflation Forecasting Models

AbstractTwenty-six industrialized and emerging countries have adopted inflation targeting monetary policy since 1990 to contain escalating inflation rate. If both the level and volatility of inflation rate have diminished perceptibly for these countries since their adoption of inflation targeting policy, as evidence overwhelmingly suggests, then the predictive performance of inflation forecasting models should have improved unambiguously for these countries after they adopted inflation targeting policy. Furthermore, inflation forecasts generated by a time-series model should be more accurate than those generated by either a structural model or a naive model after the adoption of inflation targeting policy. In this study, the predictive performance of three alternative inflation forecasting models - univariate time-series (ARIMA) model, Phillips curve model, and naive model - are carefully evaluated for a selected number of inflation-targeted countries. It is found that these models generate more accurate forecasts of inflation rate for the period following the adoption of inflation targeting policy. Furthermore, out-of-the-sample inflation forecasts generated by an ARIMA model are found to be more accurate than those generated by the other two forecasting models for most countries, especially for the period following the adoption of inflation targeting policy.Keywords: Inflation targeting, inflation forecasting models, predictive performance comparison.JEL codes: C53, E31(ProQuest: . denotes formulae omitted.)IntroductionTwenty-six industrialized and emerging countries (8 industrialized and 18 emerging countries) have adopted inflation targeting monetary policy since 1990 to combat persistently high inflation rates and inflation volatility. The first country to formally adopt an inflationtargeting policy was New Zealand (1990), which was followed by Canada (1991), Chile (1991), Israel (1992), United Kingdom (1992), Peru (1994), Australia (1994), and Sweden (1995)1. Eighteen other countries have adopted inflation targeting policy since 19952. Given the success that many of these countries have experienced in containing persistently high inflation rate, it is widely anticipated that other countries will soon adopt inflation targeting policies3.Inflation targeting monetary policy accords either the government and/or the central bank the authority to assign an explicit numerical target for the inflation rate and implement an appropriate monetary policy to achieve its inflation target4.The proponents of this policy have long claimed that inflation targeting would not only reduce inflation rate, inflation volatility, output volatility, and interest rates, but also enhance both the transparency and accountability of the monetary policy. The central bank with an explicit inflation target has to regularly publish and disseminate reports stating the bank's forecast of future inflation rate based on its outlook on the economy, the rationale for the target chosen, and the specific nature of the monetary policy to be implemented to achieve the target. Subsequently, the central bank must periodically issue reports providing an objective assessment of the success (or lack thereof) the bank has experienced in its attempt to meet the target it has chosen. Therefore, in such an environment, the central bank's decisions and the outcome of its decisions will be monitored closely by both the government and media.Empirical evidence on the merits of inflation targeting policy, however, remains somewhat inconclusive. Bernanke, Laubach, Mishkin, and Posen (1999) and Mishkin and Schmidt-Hebbel (2007) found that inflation targeting reduces inflation rate, inflation volatility, interest rates, and output growth volatility for all countries that adopted this strategy. Specifically, Mishkin and Schmidt-Hebbel showed that the average inflation rate for inflationtargeting countries has dropped from 12. …