The Central Bank’s inflation forecast plays an important role in the implementation of monetary policy. In effect the Bank’s forecast serves as a kind of intermediate policy objective, similar to that of exchange rate stability before. The reason is that a significant deviation in forecast inflation from the target calls for action by the Central Bank in a similar way to earlier depreciations or appreciations of the exchange rate, when exchange rate stability was an intermediate monetary policy objective. Thus the quality of inflation forecasting is vital.
Inflation forecasts are based on empirical studies of the relationship between the rate of inflation and several economic aggregates which are considered to influence or at least precede inflation. Special circumstances which are likely to affect price developments over the medium term are often evaluated as well. Changes in wages and the exchange rate are the aggregates which have been empirically shown to be most strongly linked to the inflation rate. Such relations are found in all conventional models of the determinants of inflation and can be attributed to mark-up pricing by companies which sell goods and services in the market and use inputs in the form of labour and imported raw materials, as well as competing with comparable imported goods.
Assessing the price outlook on the basis of the relation between wages, exchange rate and prices is not totally satisfactory insofar as this methodology does not focus on the root of the problem, i.e. excess demand in the domestic goods and labour markets which has an effect on wage and exchange rate developments. The Central Bank of Iceland Economics Division has been designing inflation models which also incorporate the impact of the output gap on inflation. This methodology has also some shortcomings by not taking into account the effect that inflation expectations have on prices, nor the feedback effects of inflation on demand. Accordingly, the Central Bank of Iceland Economics Division has launched the design of an integrated macroeconomic model addressing all these factors.
Following is the latest inflation forecast from February 2013.