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The central bank as a risk manager: quantifying and forecasting inflation risks

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  • Kilian, Lutz
  • Manganelli, Simone

Abstract

In deciding the monetary policy stance, central bankers need to evaluate carefully the risks the current economic situation poses to price stability. We propose to regard the central banker as a risk manager who aims to contain inflation within pre-specified bounds. We develop formal tools of risk management that may be used to quantify and forecast the risks of failing to attain that objective. We illustrate the use of these risk measures in practice. First, we show how to construct genuine real time forecasts of year-on-year risks that may be used in policy-making. We demonstrate the usefulness of these risk forecasts in understanding the Fed's decision to tighten monetary policy in 1984, 1988, and 1994. Second, we forecast the risks of worldwide deflation for horizons of up to two years. Although recently fears of worldwide deflation have increased, we find that, as of September 2002, with the exception of Japan there is no evidence of substantial deflation risks. We also put the estimates of deflation risk for the United States, Germany and Japan into historical perspective. We find that only for Japan there is evidence of deflation risks that are unusually high by historical standards. JEL Classification: E31, E37, E52, E58, C22

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Bibliographic Info

Paper provided by European Central Bank in its series Working Paper Series with number 0226.

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Date of creation: Apr 2003
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Handle: RePEc:ecb:ecbwps:20030226

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Keywords: deflation; forecast; inflation; monetary policy; risk;

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  1. Svensson, L-E-O, 1996. "Inflation Forecast Targeting : Implementaing and Monitoring Inflation Targets," Papers 615, Stockholm - International Economic Studies.
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Cited by:
  1. Keith Kuester & Volker Wieland, 2010. "Insurance Policies for Monetary Policy in the Euro Area," Journal of the European Economic Association, European Economic Association, vol. 8(4), pages 872-912, 06.
  2. Smets, Frank & Wouters, Raf, 2004. "Forecasting with a Bayesian DSGE model: an application to the euro area," Working Paper Series 0389, European Central Bank.
  3. D. Sornette & W. -X. Zhou, 2003. "Evidence of Fueling of the 2000 New Economy Bubble by Foreign Capital Inflow: Implications for the Future of the US Economy and its Stock Market," Papers cond-mat/0306496, arXiv.org.
  4. Marco Vega, 2004. "Policy Makers Priors and Inflation Density Forecasts," Econometrics 0403005, EconWPA.
  5. Vitor Gaspar, 2003. "The conduct of monetary policy under uncertainty," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 249-264.

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