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Economic Forecasting and Monetary Policy

Vierteljahrshefte zur Wirtschaftsforschung 2 / 2006, S. 54-64

Lorenzo Bini Smaghi

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The DIW is the largest and oldest economics institute in Germany and conducts research in many fields of economic analysis. In this contribution to the conference celebrating the 80th birthday of this important institution I feel stimulated to address a few analytical issues, raising questions rather than providing answers, and without necessarily limiting the reasoning to predefined frameworks. The conduct of monetary policy faces challenges which are quite similar to those of economic forecasting, with some additional complications. As Niels Bohr, a Nobel laureate in Physics, used to say: "Making predictions is very difficult, especially about the future." I would add: "Not only about the future". Forecasting the direction in which the economy is going is essential for monetary policy, but not sufficient as knowledge about the starting position, and possibly even the past trajectory is required. This is less simple than one would think, because some key variables are not observable. My contribution is organised as follows. I will first try to explain why forecasts are so important for central banks. I will also make a digression on some (unanswered) questions in monetary policy making. I will then examine how forecast errors may affect the monetary policy decision making and how the assessment of risks is at least as important as the central scenario of the forecast.