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How is the forecast drawn up?

The key source material for the CNB Bank Board's decisions is the CNB's macroeconomic forecast. This forecast is drawn up by the Monetary Department in interaction with the board members. It represents the CNB experts' views of the most likely future evolution of the economy, including the behaviour of the central bank itself. The forecast is based on a consistent medium-term framework taking the form of a model approach which is supplemented with an expert opinion primarily affecting the short-term forecast horizon. The most relevant for monetary policy decision-making is the inflation forecast at the so-called monetary policy horizon (about 12-18 months ahead), which affects the current interest rate settings.

The behaviour of the central bank in setting short-term interest rates is expressed in the forecast by a simple central bank reaction function which is consistent with the definition of the CNB's objectives. Thus, one particular interest rate path is consistent with each CNB forecast. However, this trajectory cannot be viewed as binding as regards the future path of interest rates. The arrival of new information since the forecast was drawn up and different views of the board members of economic developments than those outlined in the CNB forecast mean that the actual interest rate path may deviate from the forecasted path.

The forecast is prepared by a large team of specialists working in the CNB's prediction team. The process of compiling the forecast takes about one month, taking the form of a series of meetings of the prediction team. The initial meetings deal with the starting conditions of the forecast, in particular the position of the domestic economy in the business cycle. The settings of the starting conditions largely determine the message of the forecast. For this reason, the Bank Board is also involved in this discussion by means of a "meeting on the starting conditions".

Expected external economic developments are another important assumption of the CNB forecast. To estimate the future evolution of the external environment (prices of energy-producing materials, producer price indices abroad, the business cycles of the Czech Republic's major trading partners and the euro-dollar exchange rate), the CNB draws on the publication Consensus Forecasts, which brings together the forecasts of a whole range of foreign analytical teams, and market outlooks.

Alongside the estimate of the starting conditions, the initial meetings of the prediction team also deal with the so-called short-term forecast, which is drawn up using single-equation and more sophisticated models and expert judgments and which describes economic developments in the coming few quarters.

The short-term forecast for the next quarter is then entered into the core medium-term prediction model, which is made up of tens of equations. The equations describe the key relationships within the Czech economy and between the Czech economy and the rest of the world. One of the core equations models the response of short-term interest rates to future economic developments. This central bank response sends the economy back to equilibrium in the medium term and gradually returns inflation to the CNB's target. The forecast generated by the core prediction model is again subject to expert debate in the prediction team and to other potential expert adjustments. This process of integration of the expert and model views of future economic developments is the most demanding and time-consuming part of the forecasting process. At the end of this process we obtain the final version of the baseline scenario of the CNB's macroeconomic forecast.

The forecast may therefore be viewed as the outcome of model and expert procedures, detailed considerations of short-term shocks, and comprehensive considerations of medium-term and long-term trends. Along with the preparation of the most likely economic scenarios, however, the main uncertainties and risks associated with the baseline scenario of the forecast (e.g. regarding external developments, the evolution of public budgets, uncertainties regarding equilibrium values or the future development of key variables) are also discussed. On the basis of this discussion, specific alternative scenarios for the macroeconomic forecast can then be formulated at a second meeting with the Bank Board - a "meeting on alternative scenarios". The baseline scenario and any alternative scenarios are then described in the Inflation Report , which is published eight days after the forecast has been discussed at the relevant monetary policy meeting of the Bank Board.

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