Practical Models for Inflation Forecasting

Nic Johnson

There are many different schools of thought as to what causes inflation, and over the years many explanations have been put forward to explain historically observed inflation dynamics. There are monetarists, who believe that changes in-the-money supply are the most important inflationary dynamic, while Keynesian economists argue that underlying pressures in the economy play a large role in determining inflation levels.

In this chapter, we shall not delve into the academic and philosophical issues surrounding inflation but instead focus on the forecasting methods used by practitioners, including top-down, bottom-up and time-series-based models. We shall look at the appropriateness of different frameworks, depending on the type of data inputs available, as well as the frequency and length of forecast desired. Finally, we shall consider some of the differences involved with modelling inflation in the US, and other developed global markets, relative to emerging markets.

FUNDAMENTAL TOP-DOWN MODELS FOR FORECASTING INFLATION

The goal of a top-down macro inflation model is to identify economic variables that are leading indicators of changes in the price of various goods and