Blog Post

ECB’s huge forecasting errors undermine credibility of current forecasts

In the past five years ECB forecasts have proven to be systematically incorrect: core inflation remained broadly stable at 1% despite the stubbornly predicted increase, while the unemployment rate fell faster than predicted. Such forecast errors, which are also inconsistent with each other, raise serious doubts about the reliability of the ECB’s current forecast of accelerating core inflation and necessitates a reflection on the inflation aim of the ECB.

By: Date: December 6, 2018 Topic: European Macroeconomics & Governance

In its latest projections, on September 13th 2018, ECB staff foresaw a core inflation increase to 1.5% on average in 2019 and further to 1.8% on average in 2020 (core inflation does not include volatile items like energy and food).

Such forecasts, along with the renewed euro-area economic growth and the fall in the unemployment rate, constituted an argument in favour of an important monetary policy normalisation step – namely, the announced termination of net asset purchases by the end of December 2018. The timing of the first interest-rate increase might also be informed by forecasts.

How much trust should we have in the current ECB forecast? In a forthcoming paper I analyse ECB forecasts in some detail, yet let me present the two most important charts in this blog post: core inflation and unemployment rate.

I focus on core inflation and not on headline inflation, because core inflation represents the underlying inflationary pressure. A central bank has hardly any influence over the items excluded from core inflation (energy and food prices), which are primarily driven by outside factors such as weather and supply/demand conditions on global energy markets (in my forthcoming paper I assess other forecasts too: headline inflation, GDP growth and wage growth). The recent work of Grégory Claeys, Maria Demertzis and Jan Mazza also proposed to focus on core inflation.

Figure 1 shows that the ECB has stubbornly predicted a rise of core inflation at least since December 2013, the first time that core inflation forecasts were made public. All forecasts since then have proven to be systematically incorrect: core inflation continued to fall from December 2013 to early 2015 and its increase towards 1% after early 2015 is minuscule compared to the sizeable increase forecast in each quarter.

The unemployment rate forecasts are similarly characterised by large and systematic errors (Figure 2). The unemployment rate fell faster than expected in each forecast since 2013. Forecast errors were again quite large: on average, half a percentage point at the one-year forecasting horizon and one percentage point at the two-year forecasting horizon.

It is also notable that core inflation and unemployment rate forecast errors are inconsistent with each other. A faster than expected unemployment rate decline should have led to faster-than-expected inflation. But on the contrary, core inflation turned out to be lower than predicted. These forecast errors could highlight that the underlying Phillips-curve assumption of the ECB forecasts is flawed.

What to make of all this?

Certainly, the ECB is not the only institution whose forecasts turned out to be incorrect. Many other central banks, international institutions and other forecasters made large forecast errors even in the past five years, when economic conditions improved. Such forecasting failures should foster a general debate on forecasting practices. Yet the ECB’s forecast errors and its inability to lift core inflation above 1% have major implications.

First, the huge ECB forecast errors of the past five years call into question the reliability of current forecasts. At each forecast round in the past five years, ECB staff explained why this time is different and that core inflation will increase in the subsequent two years. President Draghi has always defended these forecasts at the press conferences and in other speeches. But all forecasts of the past five years proved to be grossly incorrect. Why would the current forecast be more reliable than forecasts made in the past five years?

Second, the failure to raise core inflation above 1% with a large monetary policy arsenal – at a time when GDP growth turned out to be better than expected, and the fall of the unemployment rate was faster than expected – should raise doubts about the ability of the ECB to influence core inflation.

Let us get some inspirations from Japan. Now there seems to be sufficient evidence to conclude that the Bank of Japan has failed to reach the 2% inflation target with an even more forceful monetary policy toolkit than that applied by the ECB (see, for example, the excellent book of Sayuri Shirai). And it is unlikely that the target will be reached in the years to come. In my view, the Bank of Japan will probably have to acknowledge its failure to reach the 2% target and thereby revise the target.

At the same time the Federal Reserve was successful in bringing inflation (both core and headline) back to 2%.

Whether the structural characteristics of the euro area are closer to Japan or to the US is an important issue for discussion. But I see a significant risk of not reaching the aim of close to 2% in the euro area (in terms of core inflation) in the foreseeable future.

An obvious conclusion is that we should understand better the reasons behind the repeated ECB forecasting failures. I’m sure a large number of ECB staff does nothing else but this. I also present some possible explanations in my forthcoming paper, such as the expansion of the labour force due to higher labour force participation rates and immigration. If the expansion of the labour force slows down and the recently accelerated wage growth continues, we might perhaps see the rise of core inflation.

However, core inflation has (so far) remained stable despite some wage increases, while current wage increases still remain short of the wage growth observed in the early 2000s when core inflation was close to 2%. Labour-force participation can continue to expand. The labour-market slack in the economy is significantly larger than what the narrowly defined unemployment rate suggests, as studied by the ECB and in the research of David Bell and David Blanchflower.  

Are these labour market-related explanations sufficient to explain the rigidity of core inflation? Have ECB forecasters persistently failed to properly consider these factors in their otherwise-well specified forecasting models? Or perhaps ECB core inflation forecasts were tilted upward in order to try to influence expectations? These are difficult questions to answer.

In Japan it is already visible that long-term headline inflation expectations fell back to zero (panel B of Figure 3 – unfortunately, such expectations are not available for core inflation). Long-term headline inflation expectations in the euro are also lower now than they were in 2004-2012, while the expected average headline inflation in the euro area in the next five years fell to 1.2% by early December 2018, even though  actual headline inflation was 2% in November. Further repeated ECB forecasting failures might lead to further falls in both short-run and long-run expected inflation, which could undermine the credibility of the ECB. If that happens, the ECB should start a reflection process on its inflation aim, informed by an analysis of what has affected its ability to reach a 2% core inflation. Alternatively, the ECB should explore new ways to influence core inflation – but it does not seem that such efforts will be easy.

Third, more time will be needed to see if the forecasting failures of the past five years were driven by factors whose impact will gradually fade away, or if the ECB’s ability to lift core inflation has been compromised. Till then, the ECB will surely keep its somewhat ambiguous aim of reaching inflation ‘below, but close to, 2% over the medium term’. For this period I recommend an extremely cautious approach to monetary tightening due to all the past forecasting failures. The forecasts themselves should not be enough to justify a rate increase. A rate increase is only recommended after a significant increase of actual core inflation. I also suggest making this intention clear in the ECB’s forward guidance. 


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic

Blog Post

Providing funding in resolution: Unfinished business even after Eurogroup agreement on EMU reform

The recent Eurogroup agreement on euro-area reform foresees a greater role for the European Stability Mechanism (ESM) as a backstop to the banking union. This is a welcome step forward but important issues remain. We assess the agreement on how to fund banks after resolution and the best way to organise the fiscal role in liquidity provisioning to banks. We argue that the bank resolution framework will remain incomplete and its gaps could result in important financial instabilities.

By: Maria Demertzis and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: December 7, 2018
Read article More on this topic

Blog Post

The international role of the euro

The authors assess whether the euro area should pursue a greater international role for the euro, as outlined by European Commission president Jean-Claude Juncker, and how it might go about doing so.

By: Konstantinos Efstathiou and Francesco Papadia Topic: European Macroeconomics & Governance Date: December 3, 2018
Read article More by this author

Blog Post

Green central banking

A few weeks ago, Silvia Merler discussed the rise of “ethical investing”. A related question emerging from the discussion is whether central banks should also “go green”. Silvia reviews the latest developments and opinions on this topic.

By: Silvia Merler Topic: Energy & Climate, Finance & Financial Regulation Date: December 3, 2018
Read article More on this topic

Opinion

What the "gilets jaunes" movement tells us about environment and climate policies

Simone Tagliapietra and Georg Zachmann write on the climate governance lesson European governments should learn from the "gilets jaunes" experience.

By: Simone Tagliapietra and Georg Zachmann Topic: Energy & Climate Date: November 30, 2018
Read article Download PDF

External Publication

European Parliament

How to provide liquidity to banks after resolution in Europe’s banking union

Banks deemed to be failing or likely to fail in the banking union are either put into insolvency/liquidation or enter a resolution scheme to protect the public interest. After resolution but before full market confidence is restored, the liquidity needs of resolved banks might exceed what can be met through regular monetary policy operations or emergency liquidity assistance. All liquidity needs that emerge must be met for resolution to be a success. In the euro area, this can only be done credibly for systemically important banks by the central bank.

By: Maria Demertzis, Inês Goncalves Raposo, Pia Hüttl and Guntram B. Wolff Topic: European Macroeconomics & Governance, European Parliament, Testimonies Date: November 22, 2018
Read article Download PDF

Policy Contribution

European Parliament

A monetary policy framework for the European Central Bank to deal with uncertainty

In this Policy Contribution prepared for the European Parliament’s Committee on Economic and Monetary Affairs (ECON) as an input to the Monetary Dialogue, the authors review the emerging challenges to central banks, and propose an updated definition of price stability and an adequately refined monetary policy framework.

By: Grégory Claeys, Maria Demertzis and Jan Mazza Topic: European Macroeconomics & Governance, European Parliament, Testimonies Date: November 22, 2018
Read article More on this topic

Blog Post

Euro-area sovereign bond holdings: An update on the impact of quantitative easing

Since the European Central Bank’s announcement of its quantitative easing (QE) programme in January 2015, national central banks have been buying government and national agency bonds. In this post the authors look at the effect of QE on sectoral holdings of government bonds, updating the calculations published initially in May 2016.

By: Michael Baltensperger and Bowen Call Topic: European Macroeconomics & Governance Date: November 20, 2018
Read article More on this topic More by this author

Podcast

Podcast

Backstage: Japan’s inflation problem and monetary policy options

Bruegel senior fellow Zsolt Darvas welcomes Sayuri Shirai, professor at Keio University, visiting scholar at the Asian Development Bank Institute and former Member of the Policy Board of the Bank of Japan (BOJ), for a discussion of the Japanese monetary policy outlook. 

By: The Sound of Economics Topic: Global Economics & Governance Date: October 26, 2018
Read article Download PDF

Policy Contribution

European Parliament

Excess liquidity and bank lending risks in the euro area

In this Policy Contribution prepared for the European Parliament’s Committee on Economic and Monetary Affairs (ECON) as an input to the Monetary Dialogue, the authors clarify what excess liquidity is and argue that it is not a good indicator of whether banks’ have more incentives in risk-taking and look at indicators that might signal that bank lending in the euro area creates undue risks.

By: Zsolt Darvas and David Pichler Topic: European Macroeconomics & Governance, European Parliament, Testimonies Date: September 26, 2018
Read article More on this topic More by this author

Blog Post

Big Macs in big countries: an update on euro area adjustment

Have prices moved in the direction of correcting real exchange rate misalignments everywhere in the euro area in recent years? Not between the largest euro-area economies, i.e. France, Germany and Italy, says evidence from the Big Mac index. However, latest trends may be working in the right direction in these countries too.

By: Konstantinos Efstathiou Topic: Global Economics & Governance Date: September 20, 2018
Read article More on this topic More by this author

Blog Post

Monetary policy and superstar firms

The yearly Jackson Hole gathering of central bankers has focused this year on the topic of changing market structure, the rise of superstar firms, and the implications of the way they compete for central banks.

By: Silvia Merler Topic: Global Economics & Governance Date: September 4, 2018
Read article Download PDF More on this topic

Policy Contribution

Should we care about central bank profits?

The authors investigate the ECB’s profit-making activity of the last 20 years, assessing how this was achieved and the reasons why we should care more broadly about central banks generating profits.

By: Francesco Chiacchio, Grégory Claeys and Francesco Papadia Topic: European Macroeconomics & Governance Date: August 30, 2018
Load more posts