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Heuristics versus econometrics as a basis for forecasting international inflation differentials

Tobias Rötheli (Faculty of Economics, Law and Social Sciences, University of Erfurt, Erfurt, Germany)

Foresight

ISSN: 1463-6689

Article publication date: 6 December 2018

Issue publication date: 12 April 2019

163

Abstract

Purpose

This study aims to address the issue of prediction of inflation differences for an economy that considers either fixing its exchange rate or joining a currency union. In this setting, individual countries have limited control over their inflation, and anticipating the possible course of domestic inflation relative to inflation abroad becomes an important input in policy-making. In this context, the author compares simple forecast heuristics and econometric modeling.

Design/methodology/approach

The study compares two basically different approaches. The first approach of forecasting consists of simple heuristics. Various heuristics are considered that differ with respect to the economic reasoning that goes into quantifying the forecast rules. The simplest such forecasting heuristic suggests that the average over all available observations of inflation differentials should be taken as a predictor for the future. Bringing more economic insight to bear suggests a further heuristic according to which historical inflation differentials should be adjusted for changes in the nominal exchange rate. A further variant of this approach suggests that a forecast should exclusively rely on data from earlier times under a pegged exchange rate. A fundamentally different approach to prediction builds on dynamic econometric models estimated by using all available historical data independent of the currency regime.

Findings

The author studies three small member countries of the Eurozone, i.e. Finland, Luxembourg and Portugal. For the evaluation of the various forecasting strategies, he performs out-of-sample predictions over a horizon of five years. The comparison of the four different forecasting strategies documents that the variant of the forecast heuristic that draws on data from earlier experiences under fixed exchange rates performs better than the forecast based on the estimated econometric model.

Practical implications

The findings of this study provide helpful guidelines for countries considering either joining a currency union or fixing their exchange rate. The author shows that a simple forecasting heuristic gives sound advice for assessing the likely course of inflation.

Originality/value

This study describes how economic theory can guide the selection of historical data for assessing likely future developments. The analysis shows that using a simple heuristic based on historical analogy can lead to better forecasts than the analytically more sophisticated approach of econometric modeling.

Keywords

Acknowledgements

The author would like to thank Mico Loretan, Christoph Mölleken, Ruth Parham, Mathias Zurlinden, and participants of research seminars at the European Department of the International Monetary Fund and the Swiss National Bank for comments. Two anonymous referees are acknowledged for detailed comments.

Citation

Rötheli, T. (2019), "Heuristics versus econometrics as a basis for forecasting international inflation differentials", Foresight, Vol. 21 No. 2, pp. 216-226. https://doi.org/10.1108/FS-07-2018-0070

Publisher

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Emerald Publishing Limited

Copyright © 2018, Emerald Publishing Limited

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