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Do errors in forecasting inflation lead to errors in forecasting interest rates?

Goodhart, Charles and Bin Lim, Wen (2008) Do errors in forecasting inflation lead to errors in forecasting interest rates? Discussion paper (611). Financial Markets Group, London School of Economics and Political Science, London, UK.

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In the first of three related, and consecutive, papers we showed that forecasts for short-term policy interest rates in NZ and UK deteriorated over the first six months to a point when they became useless, after the first two quarters. Moreover they were expost biased, underestimating future interest rates during upturns and the reverse during downturns. Both NZ and UK have been inflation targeters during our data period. In this second paper we ask, first whether inflation forecasts exhibit the same syndrome as the related interest rate forecasts, and whether errors in the inflation forecast may help to explain errors in the interest rate forecast. We find that the pattern of inflation forecast errors is qualitatively much the same as those for interest rates, but that the inflation forecasts are quantitatively better, both in terms of prediction error and of bias. The evidence on the relationship between inflation forecast errors and interest rate forecast errors is mixed. Over the whole time period, both in NZ and UK, there is no such relationship. But if one should strip out certain short periods, when domestic interest rates appear to have been affected by external factors, then there does seem to be such a relationship, with under (over) estimates of future inflation associated with under (over) estimates of future policy interest rates.

Item Type: Monograph (Discussion Paper)
Official URL:
Additional Information: © 2008 The Authors
Divisions: Financial Markets Group
Subjects: H Social Sciences > HB Economic Theory
H Social Sciences > HJ Public Finance
Sets: Research centres and groups > Financial Markets Group (FMG)
Collections > Economists Online
Collections > LSE Financial Markets Group (FMG) Working Papers
Date Deposited: 09 Jul 2009 16:10
Last Modified: 08 Jan 2021 01:16

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