FRANKFURT (MNI) – The European Central Bank has developed and is
currently testing a new approach for measuring short-term inflation
developments that takes into account how individual CPI components can
influence each other and overall consumer price growth.

The use of Bayesian Vector Autoregression (BVAR) models is one such
approach, the ECB said in its monthly bulletin, published on Thursday.

BVAR models, which had initially been used only to forecast a
limited number of variables, are now being looked at to take on the
large data sets required to assess interaction among the inflation
components, as well as their impact on overall price change.

“The general aim of this approach is to model the components and
determinants of inflation described above in an integrated manner, such
that the need for expert judgement in order to capture interactions
across variables is reduced,” the ECB said.

The model could also be used as a forecasting tool, conditional on
how the inflation components themselves might change.

“Alternatively, the tool can be used to generate its own forecasts
for these variables and hence provide ‘unconditional’ forecasts of
inflation,” the bulletin

Currently, ECB staff projections make use of six equations, one for
each of the main HICP components: unprocessed food, processed food,
energy, industrial goods and services excluding energy, and producer
prices.

“The advantage of these equations is that they provide a simple way
of interpreting inflation fluctuations, making it possible to forecast
inflation conditional on the specific future paths of the determinants
listed above and permitting a focus on the heterogeneity of the HICP
sub-components,” the report read.

However, the drawback to such an approach, which implicitly
suggests no interaction between the components, is that it fails to
capture “the pass-through mechanism” that may exist among the
components, as well as its impact on overall inflation.

“Such effects can be introduced ad hoc, through the inclusion of
expert judgement,” the ECB said. “However, the extent to which their
impact persists beyond the very short-term evolution of inflation would
be difficult to gauge without a relevant model structure.”

“In addition, the reliance on a set of exogenous assumptions
implies that the model can only forecast inflation when an assumed path
for the full set of these variables is available.”

–Frankfurt bureau: +49-69-720 142, email: frankfurt@marketnews.com

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