Forecasting UK inflation bottom up

Abstract

We forecast CPI inflation in the United Kingdom up to one year ahead using a large set of monthly disaggregated CPI item series combined with a wide set of forecasting tools, including dimensionality reduction techniques, shrinkage methods and non-linear machine learning models. We find that exploiting CPI item series over the period 2011–19 yields strong improvements in forecasting UK inflation against an autoregressive benchmark, above and beyond the gains from macroeconomic predictors. Ridge regression and other shrinkage methods perform best across specifications that include item-level data, yielding gains in relative forecast accuracy of up to 70% at the one-year horizon. Our results suggests that the combination of a large and relevant information set combined with efficient penalisation is key for good forecasting performance for this problem. We also provide a model-agnostic approach to address the general problem of model interpretability in high-dimensional settings based on model Shapley values, partial re-aggregation and statistical testing. This allows us to identify CPI divisions that consistently drive aggregate inflation forecasts across models and specifications, as well as to assess model differences going beyond forecast accuracy.