Central banks’ forecasts and their bias: Evidence, effects and explanation

Abstract

Through empirical analysis this paper shows that inflation forecasts produced for monetary policy councils in inflation targeting countries may be subject to bias towards the target. There is no clear evidence of such bias for other inflation forecasts. To explain this observation a model is constructed to analyse the effectiveness of monetary policy committee voting when the inflation forecast signals, upon which decisions are based, may be subject to manipulation. Using a discrete time intertemporal model, we examine the distortions resulting from such manipulation under a three-way voting system. We find that voting itself creates persistence and volatility in inflation. In the case when the expected value of the inflation distribution is not far from the target, alterations to the forecast signal, even if well intentioned, results in a diminished probability of achieving the inflation target and an increase in persistence. However, if committee members ‘learn’ in a Bayesian manner, this problem is mitigated.