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The Czech National Bank's Forecasting THE CZECH NATIONAL BANK’S FORECASTING AND POLICY ANALYSIS SYSTEM THE CZECH NATIONAL BANK’S FORECASTING AND POLICY ANALYSIS SYSTEM Edited by Warren Coats, Douglas Laxton, and David Rose Czech National Bank PRAGUE TABLE OF CONTENTS TABLE OF CONTENTS Page Preface 5 Zdenûk TÛma 1. Historical Perspective on the Development of the Forecasting and Policy Analysis System 7 Ale‰ âapek, Tibor Hlédik, Viktor Kotlán, Stanislav Polák and David Vávra Introduction 8 A Brief History of Monetary Policy in the Czech Republic 9 New Requirements of the Forecasting and Analytical System 13 2. Developing Consistent Scenarios with the Forecasting and Policy Analysis System 27 Ale‰ âapek, Tibor Hlédik, Viktor Kotlán and David Vávra Introduction 28 Starting Conditions 28 Implementing the New FPAS: Principles and Objectives 30 Implementing the New FPAS: Process of Creating the Integrated Forecasts 33 Applying Judgement in the Forecast 39 Lessons Learned 40 Appendix: An Example of Forecast Report 44 3. Models Used in the Forecasting and Policy Analysis System 51 Stanislav Polák and David Vávra Introduction 52 Appendix: Other Models Used at the Czech National Bank 57 4. The Quarterly Projection Model and its Properties 63 Jaromír Bene‰, Tibor Hlédik, David Vávra and Jan Vlãek Introduction 64 Why Start with a Small Model? 64 The Essential Issues for the Model 67 Key Equations in the Quarterly Projection Model 69 Calibration of the Model 76 Estimation Versus Calibration 76 Calibration of the Core QPM 77 Properties of the QPM 81 5. A Multivariate Filter for Measuring Potential Output and the NAIRU 99 Jaromír Bene‰ and Papa N’Diaye Introduction 100 The Multivariate System 102 AMethodology for Pre-Filtering: The PC Filter 104 Estimates of Real Monetary Conditions 105 2 TABLE OF CONTENTS Estimates of Output and Unemployment Gaps 113 Comparison with Gaps Derived from the HP Filter 113 Appendix: The Multivariate Kalman Filter 114 6. Risk Analysis and Confidence Bands for the Forecast 119 Jaromír Bene‰, David Vávra and Jan Vlãek Introduction 120 Assessment of Risks 120 Understanding the Policy Implications of Uncertainty 121 An Overview of Stochastic Simulation and the Creation of Confidence Bands 122 Choosing the Shocks 123 Examples of Confidence Bands 124 Conclusion 126 Appendix: The Stochastic Simulation Framework for Computing Confidence Intervals 126 Bibliography 133 3 ACKNOWLEDGEMENT The work on the Czech National Bank’s Forecasting and Policy Analysis System was carried out and this documentation prepared with the technical assistance of the Monetary Affairs and Exchange Department of the International Monetary Fund. The Czech National Bank wishes to thank the IMF for the excellent assistance provided, and particularly Douglas Laxton, Papa N’Diaye and David Rose, all of whom worked with CNB management and economists to develop the system documented herein. THE EDITORS Warren Coats - Monetary Affairs and Exchange Department of the International Monetary Fund Douglas Laxton - Research Department of the International Monetary Fund David Rose - QED SOLUTIONS, on contract for this project with the Monetary Affairs and Exchange Department of the International Monetary Fund The editors wish to thank Michel Juillard for assistance in developing some of the software used in this project. THE AUTHORS Jaromír Bene‰ - Senior Economist in the Economic Modelling Division, Monetary and Statistics Department, Czech National Bank Ale‰ âapek - Executive Director of the Monetary and Statistics Department, Czech National Bank Tibor Hlédik - Advisor to the Bank Board of the Czech National Bank Viktor Kotlán - Director of the Monetary Policy Division, Monetary and Statistics Department, Czech National Bank Papa N’ Diaye - Research Department of the International Monetary Fund Stanislav Polák - Director of the International Economic Analyses Division, Monetary and Statistics Department, Czech National Bank David Vávra - Director of the Economic Modelling Division, Monetary and Statistics Department, Czech National Bank Jan Vlãek - Economist in the Economic Modelling Division, Monetary and Statistics Department, Czech National Bank 4 PREFACE The Czech National Bank (CNB) now has more than five years of experience with inflation targeting. Much has been achieved during this time. At present, the Czech Republic enjoys low inflation, and inflation expectations seem to be firmly anchored at low levels. Monetary policy decision-making is systematic and transparent, thereby enhancing the credibility of the CNB. The Czech Republic was the first transition country to adopt inflation targeting, and as such had to face many challenges. The new regime was introduced soon after a period of currency turmoil in May 1997, which resulted in high inflation expectations. Moreover, the Czech Republic is a small and very open economy, subject to strong exogenous shocks. These factors have made the achievement of inflation targets more difficult than in some other countries. The Czech experience with inflation targeting thus illustrates that the ultimate purpose of inflation targeting is not to announce inflation targets and then hit them mechanically. It is a mistake to confuse inflation targeting with inflation obsession. The aim is to design a rule-based monetary policy framework characterised by a high degree of transparency and accountability. Such a framework allows an independent central bank to commit credibly to its long-term goal of price stability, and at the same time preserves enough discretion for an active anti- cyclical monetary policy that takes into account not only inflation, but also other factors such as variability of output. The shift towards such a regime from a fixed exchange rate system, however, requires a radical change in the central bank’s mentality. This is perhaps the biggest challenge that the CNB has faced in recent years. All this said, it is not surprising that the Czech inflation-targeting regime has gone through an evolutionary process, during which many of its details have been adjusted in response to the changing needs, newly acquired experience and evolving thinking of the central bank. The most important changes have included the specification of inflation targets, the development of a communication strategy, co-operation with the government and the approach to dealing with high exchange rate volatility. Inflation targeting requires us to assess all the available information in a systematic and complex way, and is thus more demanding from this point of view than the alternative monetary strategies such as exchange rate fixing or monetary targeting. Therefore, much work has been done at the CNB over the past five years to improve our analytical tools, leading to substantial development in our internal analytical processes. These changes culminated a year ago, when the CNB settled upon a new forecasting process. This integrates expert judgement and sectoral analyses – which were the key pillars of the CNB’s forecasting tool-kit in the first years of inflation targeting – with a small-scale macroeconomic model developed by the CNB’s staff with the assistance of the International Monetary Fund. By doing so, I believe the CNB has moved close to the state-of-the-art among the inflation-targeting central banks around the world. It must always be borne in mind, of course, that even highly developed, technically advanced and institutionally well-organised forecasting procedures are not an automatic pilot. They are no more – but also no less – than an important input into the monetary policy process. Eventually, the decision is always based not only on the central forecast itself, but also on discussion of the associated risks by the Bank Board. Good analytical tools, however, can be helpful even in this respect, by enabling us to simulate the different alternative scenarios demanded by the Board in a consistent manner. I am glad that the progress we have jointly achieved in developing the Czech National Bank’s Forecasting and Policy Analysis System has been documented in a comprehensive way and is presented to all interested readers in this publication. Zdenûk TÛma Governor Czech National Bank February 2003 5 CHAPTER 1 CHAPTER 1 Historical Perspective on the Development of the Forecasting and Policy Analysis System By Ale‰ âapek, Tibor Hlédik, Viktor Kotlán, Stanislav Polák and David Vávra 1 1 Ale‰ âapek is Executive Director of the Monetary and Statistics Department, Tibor Hlédik works as an advisor to the Bank Board of the Czech National Bank. Viktor Kotlán is a director of the Monetary Policy Division, Stanislav Polák is a director of the International Economic Analyses Division and David Vávra is a director of the Economic Modelling Division, all Monetary and Statistics Department, Czech National Bank. 7 HISTORICAL PERSPECTIVE ON THE DEVELOPMENT OF THE FORECASTING AND POLICY ANALYSIS SYSTEM INTRODUCTION In December 1997, following an exchange rate crisis, the Czech Republic adopted a series of end-year inflation targets for monetary policy. The new regime proved very effective in combating inflation and anchoring inflation expectations in the aftermath of the crisis and continued to evolve in the subsequent years toward a more transparent full-fledged inflation targeting regime where monetary policy is anchored by a medium-term perspective. Most recently, the character of the regime was further enhanced by publication of unconditional forecasts based on changing interest rates to move the Czech National Bank’s forecast for inflation over time toward the mid-point
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