Consumers’ approach to the credibility of the inflation forecasts published by central banks: A new methodological solution

Abstract

Modern monetary policy focuses on credibility and shaping inflation expectations. In keeping with the concept of inflation forecast targeting, the inflation forecasts published by central banks play a crucial role in the instrument rate decision-making process and may be treated as a specific intermediate target. This study proposes an inflation forecast credibility index, the scope of which is narrowed to non-specialists’ approach to inflation forecasts. The credibility of the forecast is defined as the ability to shape consumers’ inflation expectations. This ability is measured as the absolute difference between the central paths of inflation forecasts (the mode values) in the one-year forecast horizon and one-year consumers’ inflation expectations. The inflation forecast is represented in the study as a function of forecast attributes (accuracy, similarity, and deviation from the inflation target). The credibility function of the forecast is derived from belief function theory, normally distributed, and determined by the linear function of the chosen forecast attributes. The importance of these attributes depends on whether monetary policy was conducted before or after reaching the zero lower bound on the policy rate. The credibility index is calculated for the inflation forecasts published by the central banks of the United Kingdom and Sweden. The main conclusion of the study is that the deviations of the forecast in the last year of the forecast horizon and similarity between consecutive forecasts are important forecast attributes for shaping the inflation expectations of consumers before and after reaching the zero lower bound on the policy rate, and may determine the inflation forecast's credibility. However, the similarity to consecutive forecasts affects the forecast's credibility in opposite ways before and after reaching the zero lower bound on the policy rate.