Forecasting inflation under uncertainty : The forgotten dog and the frisbee

This study is an endeavour to analyse the aspect of adhering to simplicity instead of complexity when one is striving to make a forecast and facing an unprecedented amount of uncertainty. There is substantial evidence on the exchange rate pass-through and equally ample evidence to suggest that the complex models are outperformed by simple solutions and heuristics. In this context, it seems that the Bank of England’s post-Brexit forecast is an example of the sub-optimal performance of complex models in the face of high tides of uncertainty. To illustrate this point further, this study employed the data on the consumer price index from January 1989 to June 2019 and compared the post-Brexit inflation forecast by the Bank of England with an ARIMA model and a simple rule which was based on the Bank of England’s estimates on pass-through due to exchange rate movements, similar in magnitude to the ones associated with Brexit. It showed that the actual path of inflation substantially diverged from the Bank of England’s forecast as the effects of depreciation started to kick in. It implied that in the highly uncertain environment post-Brexit, a better prediction could have been possible by allocating some weights to the effects of sharp depreciation, indeed, that would have been a matter of judgment and simplicity.