TAILIEUCHUNG - Forecast uncertainty and the Bank of England interest rate decisions

When comparing time series models across countries, there is always a trade-off between the need to implement the comparison as neatly as possible and the need to fit models as best as possible to individual countries. By using different lags for different countries, we would run the risk to lose full comparability. By running the exercise with a common specification across countries we are running the risk of comparing Chile with other countries on the basis of a model that is possibly misspecified for other countries. In principle, one could try to determine the optimal lag-length for each interest rate series and country considered (a. | . .DEUTSCHE . BUNDESBANK EUROSYSTEM Forecast uncertainty and the Bank of England interest rate decisions Guido Schultefrankenfeld Discussion Paper Series 1 Economic Studies No 27 2010 Discussion Papers represent the authors personal opinions and do not necessarily reflect the views of the Deutsche Bundesbank or its staff. Editorial Board Klaus Dullmann Frank Heid Heinz Herrm ann Karl-Heinz Todter Deutsche Bundesbank Wilhelm-Epstein-StraBe 14 60431 Frankfurt am Main Postfach 10 06 02 60006 Frankfurt am Main Tel 49 69 9566-0 Telex within Germany 41227 telex from abroad 414431 Please address all orders in writing to Deutsche Bundesbank Press and Public Relations Division at the above address or via fax 49 69 9566-3077 Internet http Reproduction permitted only if source is stated. ISBN 978-3-86558-672-8 Printversion ISBN 978-3-86558-673-5 Internetversion Abstract To assess the Bank of England Monetary Policy Committee decisions about the Official Bank Rate under forecast uncertainty I estimate simple forecast-based interest rate rules augmented by the forecast standard deviations recovered directly from the Inflation Report fan charts. I find that interest rate decisions react to deviations of the medium-term forecasts for inflation from target in order to pursue the inflation target. Forecast inflation uncertainty has a strongly intensifying effect on this reaction. Information from output growth is utilized in the form of near-term forecasts. The associated forecast uncertainty of output growth has an attenuating effect on the interest rate reaction. When accounting for asymmetries in forecast uncertainty I find that forecast upward risks to inflation contribute to the intensifying effect of forecast inflation uncertainty. The corresponding downward risks have no significant impact. As regards output growth asymmetries in the forecast uncertainty have no significant impact on the interest rate reaction at all. Moreover I find that forecast risks to

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