Zdeněk Tůma: Forecasting at central banks Speech by Mr Zdeněk Tůma, Governor of the Czech National Bank, at the Forecasting Dinner 2004, 20 February 2004. *  *  *  Ladies and gentlemen, dear colleagues, It is my pleasure to be here tonight to share with you some thoughts on the forecasting process at central banks, and the Czech National Bank in particular. It is generally recognised that central bank policies must be forward-looking. As emphasised by Milton Friedman, for example, there are long lags between monetary policy actions and their impact on the economy. This means that policies responding only to the current state of the economy might miss the turning points and be pro-cyclical rather than stabilising. Therefore, central banks have always been among the leaders in the macroeconomic forecasting field. The actual way in which forecasts are produced and used at central banks has, however, changed substantially over the past few decades. The changes have reflected developments in both the economic (and econometric) theory and in monetary policy regimes. First of all, the large-scale models that were used in the 1950s to 1970s were subject to strong criticism. They were hit by a series of structural breaks, which made the previously observed relationships unreliable. Consequently, it was argued that these breaks were not a result of bad luck only, but also reflected a lack of microeconomic foundations of the models, neglect of forward-looking expectations and ad hoc econometric restrictions.

Inflation targeting, or following Svensson “inflation forecast targeting,” has placed the forecasting process at the heart of monetary policy decision-making. Under inflation targeting, the forecasting process centres around future price developments. This does not necessarily mean, though, that central bankers are obsessed with inflation. In fact, inflation targeting requires assessing all the available information, including real economic developments, monetary analysis and external balance of the economy, in a systematic and complex way. It is hence more demanding from this point of view than the alternative monetary strategies. The inflation forecast is not only an important internal decision-making tool, but also a crucial communication device. Monetary policy has become considerably more transparent over recent decades. It is now commonly believed that open communication of monetary policy is beneficial to the stability and predictability of its transmission into the economy, and is also crucial for the accountability of an independent central bank. As a result, the inflation forecast, including its underlying assumptions and policy implications, is openly explained to the public. Nonetheless, we must always bear in mind that even highly developed, technically advanced and wellorganised forecasting procedures are not an automatic pilot for inflation-targeting central banks. They are no more - but also no less - than an important input into the monetary policy process. Eventually,  BIS Review 11/2004  1  the decision is always based not only on the central forecast itself, but also on the decision-makers’ discussions about all the associated risks.