Assessing the Economic Value of Probabilistic Forecasts in the Presence of an Inflation Target

We consider the fundamental issue of what makes a “good” probability forecast for a
central bank operating within an inflation targeting framework. We provide two examples
in which the candidate forecasts comfortably outperform those from benchmark
specifications by conventional statistical metrics such as root mean squared prediction
errors and average logarithmic scores. Our assessment of economic significance uses
an explicit loss function that relates economic value to a forecast communication
problem for an inflation targeting central bank. We analyse the Bank of England’s
forecasts for inflation during the period in which the central bank operated within a strict
inflation targeting framework in our first example. In our second example, we consider
forecasts for inflation in New Zealand generated from vector autoregressions, when the
central bank operated within a flexible inflation targeting framework. In both cases, the
economic significance of the performance differential exhibits sensitivity to the
parameters of the loss function and, for some values, the differentials are economically
negligible.