Forecasting inflation with consumer survey data – application of multi-group confirmatory factor analysis to elimination of the general sentiment factor

This paper (1) examines the properties of survey based households’ inflation expectations and investigates their forecasting performance. With application of the individual data from the State of the Households’ Survey (50 quarters between 1997Q4 and 2010Q1) it was shown that inflation expectations were affected by the consumer sentiment. Multi-Group Confirmatory Factor Analysis (MGCFA) was employed to verify whether a set of proxies provides a reliable basis for measurement of two latent phenomena – consumer sentiment and inflation expectations. Following the steps proposed by Davidov (2008) and Steenkamp and Baumgartner (1998), it appeared that it was possible to specify and estimate a MGCFA model with partial measurement invariance. Thus it was possible to eliminate the influence of consumer sentiment on inflation expectations and at the same time to obtain individually corrected answers concerning the inflation expectations. Additionally, it was shown that the linear relation between consumer sentiment and inflation expectations was stable over time. As a by-product of analysis, it was possible to show that respondents during the financial crisis were much less consistent in their answers to the questions of the consumer questionnaire. In the next step of the analysis, data on inflation expectations were applied to modelling and forecasting inflation. It was shown that with respect to standard ARIMA processes, inclusion of the information on the inflation expectations significantly improved the in-sample and out-of-sample forecasting performance of the time-series models. Especially out-of-sample performance was significantly better as the average absolute error in forecasts of headline and core inflation was reduced by half. It was also shown that models with inflation expectations based on the CFA method (after elimination of the consumer sentiment factor) provided better in-sample forecasts of inflation. Nevertheless, it was not confirmed for the out-of-sample forecasts. (1) Project financed by the National Bank of Poland. Polish title of the project: "Prognozowanie inflacji na podstawie danych koniunktury gospodarstw domowych. Zastosowanie konfirmacyjnej analizy czynnikowej dla wielu grup do oczyszczenia prognoz inflacji z czynnika ogólnego nastroju gospodarczego."