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Learning from Errors While Forecasting Inflation: A Case for Intercept Correction

Author

Listed:
  • Muhammad Jahanzeb Malik

    (State Bank of Pakistan.)

  • Muhammad Nadim Hanif

    (State Bank of Pakistan.)

Abstract

Structural changes are quite common in macroeconomic time series. Moreover, any underlying macroeconomic relationship cannot be correctly specified unless we know the true model. Structural changes in time series and misspecification in empirical model are observed as shifts in the constant of the underlying relationship between the subject variables of interest. Forecasting from such a model assuming 'no structural break' and 'correct model' is tantamount to ignoring important aspects of underlying economy and mostly results in forecast failure(s). Intercept correction (IC) is a method for accommodating such ignored structural break(s) and omitted variable(s). We use a simple model (for July 1991 to March 2016) to forecast inflation for 25 countries and compare its performance with a) the same model with optimal IC, b) the same model with half IC, and c) a random walk model. Optimal IC approach, though computational intensive, outperforms in forecasting next period inflation compared to one from a) the same model without IC, b) the same model with half intercept correction, and c) random walk model without IC. For the particular class of inflation models under study, over the time period specified, 'quarter IC' works best among the fixed IC rules.

Suggested Citation

  • Muhammad Jahanzeb Malik & Muhammad Nadim Hanif, 2019. "Learning from Errors While Forecasting Inflation: A Case for Intercept Correction," International Econometric Review (IER), Econometric Research Association, vol. 11(1), pages 24-38, April.
    • Handle: RePEc:erh:journl:v:11:y:2019:i:1:p:24-38
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    References listed on IDEAS

    as
    1. Muhammad Nadim Hanif & Muhammad Jahanzeb Malik, 2015. "Evaluating the Performance of Inflation Forecasting Models of Pakistan," SBP Research Bulletin, State Bank of Pakistan, Research Department, vol. 11, pages 43-78.
    2. Jennifer L. Castle & Michael P. Clements & David F. Hendry, 2016. "An Overview of Forecasting Facing Breaks," Journal of Business Cycle Research, Springer;Centre for International Research on Economic Tendency Surveys (CIRET), vol. 12(1), pages 3-23, September.
    3. Clements, Michael P & Hendry, David F, 1996. "Intercept Corrections and Structural Change," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 11(5), pages 475-494, Sept.-Oct.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Forecasting; Structural changes; Intercept correction; Misspecification; Inflation models.;
    All these keywords.

    JEL classification:

    • C01 - Mathematical and Quantitative Methods - - General - - - Econometrics
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods

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