Forecasting euro area inflation with machine-learning models

Inflation forecasts and their risks are key for monetary policy decisions. The strategy review concluded in 2021 highlighted how most Eurosystem models used to forecast inflation are linear. Linear models assume that changes in, for example, wages, always have the same fixed, proportional effect on inflation. A new machine learning model, recently developed at the ECB, captures very general forms of non-linearity, such as a changing sensitivity of inflation dynamics to prevailing economic circumstances. Forecasts from this machine learning model closely track Eurosystem staff inflation projections, suggesting that these projections capture mild non-linearity in inflation dynamics – likely owing to expert judgement – and are in line with state-of-the-art econometric methodologies. JEL Classification: C52, C53, E31, E37