Working Paper no. 87: Wages and prices of foreign goods in the inflationary process in Iceland
Central Bank of Iceland has published a research paper by Ásgeir Daníelsson, economist in the bank‘s Economics and Monetary Policy Department. The paper discusses econometric methods for estimation of equations to forecast inflation in Iceland.
Reasons why estimates of the influence of changes in wages are frequently insignificant are explained, and it is shown that in such circumstances it makes sense to use that CPI, unit labour cost, and the price of foreign goods in ISK are cointegrated to forecast inflation. It is shown how large volatility in changes in wage rates, and especially large volatility in changes in the price of foreign goods, compared to volatility in the rate of inflation, contributes to lower estimates of the coefficients for changes in the wage rate, and in the price of foreign goods in equations for the rate of inflation.
The paper presents an estimated forecast equation for the rate of inflation. Included in this equation, as an error-correction term, is the residual from a univariate AR equation for the residual from the cointegrated relationship between the CPI, the unit labour cost, and the price of foreign goods. This equation is used for out-of-sample forecasting of the rate of inflation in 2018-2020. These forecasts are marginally better than forecasts obtained using the equation in CBI‘s macro model, QMM, but significantly worse than forecasts obtained by using naive methods.
The research paper can be accessed here: Working paper no. 87: Wages and prices of foreign goods in the inflationary process in Iceland