A new model to forecast energy inflation in the euro area

Energy inflation is a major source of headline inflation volatility and forecast errors, therefore it is critical to model it accurately. This paper introduces a novel suite of Bayesian VAR models for euro area HICP energy inflation, which adopts a granular, bottom-up approach – disaggregating energy into subcomponents, such as fuels, gas, and electricity. The suite incorporates key features for energy prices: stochastic volatility, outlier correction, high-frequency indicators, and pre-tax price modelling. These characteristics enhance both in-sample explanatory power and forecast accuracy. Compared to standard benchmarks and official projections, our BVARs achieve better forecasting performance, particularly beyond the very short term. The suite also captures a sizable variation in the impact of commodity price shocks, pointing to higher elasticities at higher levels of commodity prices. Beyond forecasting, our framework is also useful for scenario and sensitivity analysis as an effective tool to gauge risks, which is especially relevant amid ongoing energy market transformations. JEL Classification: C32, C53, E31, E37