In the late 1960s, academic economists like Milton Friedman and Edmund Phelps established that there was a connection between inflation and unemployment. In its simplest form, when more people are working, they have more spending power, which will increase demand. This is how central banks first became interested in inflation expectations.
“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output,” Friedman said.
So, if a rise in the cost of living follows excessive growth in the money supply, then one needs to follow the money to understand or predict inflation. In practice, the path from increased money supply to increased costs isn’t that straightforward, because inflation historically follows money supply growth with a lag of about two years.
Fast forward 50 years, and inflation and unemployment have decoupled somewhat due to the effects of globalization and automation. The economy is quite different today than it was in the 1960s, when central bankers first seized upon the importance of inflation expectations as they relate to the connection between inflation and unemployment.
That has reduced the relevance of inflation forecasting for many observers who question how a relationship predicated on the state of the economy pre-globalization and automation could realistically be expected to apply in the same way today.
Guesses masquerading as forecasts
Central banks carefully monitor inflation expectations via surveys of households and businesses, which form the basis for their inflation forecasts. But there are questions around how reliable that data is when those being surveyed have never studied economics and don’t have access to the data – with detractors arguing it’s a scenario that lends itself more to guessing than forecasting.
Barry Ritholtz, co-founder and CIO of Ritholtz Wealth Management takes it a bit further by labelling sentiment surveys “a special form of junk pseudoscience.” In a recent blog post, he goes on to say that these “surveys are useless – most of the time – the exception being on rare occasions at the extremes.”
Taking things too far
In fact, inflation rate predictions have demonstrated little to no ability to provide insight into near-term (6-12 months) future inflation, and have been less accurate when looking several years out – even though that’s exactly what the 5-Year, 5-Year forward inflation expectation rate is meant to do.
It’s hard to imagine the people and business owners surveyed to gather data for inflation forecasting could have any idea what will happen so far in the future, or that personal experiences won’t affect their responses.
Inflation expectations actually tend to be a contrarian indicator at more extreme readings, often coming in at their lowest right before a spike and highest just prior to expectations coming down.
Just like investors piling into a stock right before it tanks or dumping it when about to reach its nadir, people’s inflation expectations seem to follow a similar pattern of being completely wrong and ill-timed.
Yet while perceptions and guesswork shouldn’t affect U.S. Federal Reserve decisions, that central bank had said it relies on these surveys for insight into what’s happening – and that they can influence monetary policy decisions.
Why is inflation forecasting so widely used?
Like with many other aspects in the financial markets and the economy, logic and hard numbers are only part of the equation. While inflation expectations may be subjective, they can impact what happens in the economy, just like investor behaviour can impact the movement of a stock’s price.
Unanchored inflation expectations can lead to inflation getting worse before it gets better. If people expect inflation to become or remain high, they might change their behaviour in ways that make that expectation a self-fulfilling prophecy and negate the intended effect of rate increases meant to control runaway inflation.
People clamour to buy things before the price goes up. Workers push for raises if they think their cost of living is heading higher. And businesses might adopt preemptive price increases if their input costs are poised to rise.
These are dangerous feedback loops that could make it harder for central bankers to drive inflation back to target levels. It also amplifies market volatility as everyone tries to figure out what will happen next with regards to monetary policy decisions.
This is the reason policymakers carefully monitor households’ and firms’ inflation expectations through their various surveys, and factor them into policy decisions. The success of these policies can hinge on the ability to convey the intended effect to households and steer their expectations accordingly.
Everyone got it wrong in 2021
With the benefit of hindsight, it’s no exaggeration to say that almost everyone got the U.S. inflation story wrong in 2021. From private-sector forecasters to members of the Federal Open Market Committee, the International Monetary Fund, the Congressional Budget Office, the Biden administration, and even the financial markets themselves (as evidenced by bond prices).
Senior government officials have had to walk back comments about inflation being temporary as prices soared well beyond predictions. In fact, the only thing that proved transitory was the use of that term to describe inflation, after U.S. Federal Reserve Chairman Jerome Powell banished it from the Fed lexicon in November 2021.
Whether that’s a sign that inflation expectations should be treated differently or relied upon less heavily isn’t something economists and central bankers have made a clear position on at the time of writing.
Expect less of expectations
The Federal Reserve spends a lot of time worrying about inflation expectations, but maybe they shouldn’t.
“I have discussed all too frequently why sentiment is mostly useless; now apply that sentiment to future conditions and you end up with these sorts of attempts to capture uncertainty as an index with predictive value,” Ritholtz wrote on his blog. “I have yet to find one that is useful a priori.”
A 2021 Fed paper made the same point.
“Economists and economic policymakers believe that households’ and firms’ expectations of future inflation are a key determinant of actual inflation,” the paper said.
“A review of the relevant theoretical and empirical literature suggests that this belief rests on extremely shaky foundations, and a case is made that adhering to it uncritically could easily lead to serious policy errors.”
Still, some will continue to believe in the value of forecasts, while others will argue John Kenneth Galbraith was correct when he remarked that “the only function of economic forecasting is to make astrology look respectable.”
Whether you think it’s a valuable indicator or complete bunk, it’s likely not going away, if only because it provides some interesting insights into how people might behave and some powerful folks still feel it can help them gain a sense of where inflation might be headed.