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Adaptive models and heavy tails with an application to inflation forecasting

Author

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  • Davide Delle Monache

    (Bank of Italy)

  • Ivan Petrella

    (WBS
    CEPR)

Abstract

This paper introduces an adaptive algorithm for time-varying autoregressive models in the presence of heavy tails. The evolution of the parameters is determined by the score of the conditional distribution, the resulting model is observation-driven and is estimated by classical methods. In particular, we consider time variation in both coefficients and volatility, emphasizing how the two interact with each other. Meaningful restrictions are imposed on the model parameters so as to attain local stationarity and bounded mean values. The model is applied to the analysis of inflation dynamics with the following results: allowing for heavy tails leads to significant improvements in terms of fit and forecast, and the adoption of the Student-t distribution proves to be crucial in order to obtain well calibrated density forecasts. These results are obtained using the US CPI inflation rate and are confirmed by other inflation indicators, as well as for CPI inflation of the other G7 countries.

Suggested Citation

  • Davide Delle Monache & Ivan Petrella, 2016. "Adaptive models and heavy tails with an application to inflation forecasting," BCAM Working Papers 1603, Birkbeck Centre for Applied Macroeconomics.
    • Handle: RePEc:bbk:bbkcam:1603
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    More about this item

    Keywords

    adaptive algorithms; inflation; score-driven models; student-t; time-varying parameters.;
    All these keywords.

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation

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