Will the global inflation remain temporary?

In hindsight, the forecasting of inflation has arguably been pretty straightforward for many years as inflation has not strayed too far from central bank targets, which are mostly around the 2% mark. Inflation has generally been a little low and hence the likes of the Fed and ECB had made recent attempts to temporarily, at least, aim for a higher rate. But, for the most part, becalmed inflation has meant easy forecasting. It has probably also afforded central banks a good deal of credibility as their achievement of target, or sub-target inflation has been seen as a vindication of the adoption of targets in the first place.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy thinks this might mean that those that want to forecast inflation, whether they be professional forecasters working for financial institutions, firms, or just the man on the street, probably look to central banks for credible guidance. A study by the St Louis Fed a few years ago suggested that Fed forecasts are generally more accurate than private economists. A fact that it put down to things like its ability to devote more resources to forecasting. An inside knowledge of the likely course of monetary policy might have helped as well some decades ago but this advantage has probably waned as central banks opened up about the likely course of policy by producing policy rate forecasts, for instance. If central banks are the best then economists might gravitate towards them, reticent to think that inflation will deviate too far from the central banks’ forecasts. The wider financial market as a whole might be drawn by the same magnet as well as traders and investors seem reticent to price things like inflation swaps too far from central bank forecasts. Of course, we do see these implied inflation forecasts deviate from time to time, but that’s usually more a reflection of financial market dislocation, as we’ve seen during the pandemic, than any wholesale change in longer-term inflation expectations. But is this convergence to the inflation target dangerous?

An audit of the Bank of England’s inflation forecasts back in 2015 pointed out a tendency for the Bank’s two-year inflation forecasts to cluster around 2%. If we look across central banks, we do tend to see a consistent trend of on-target inflation forecasts when we look out a few years. Even in Japan, where it seems that the BoJ has no chance of getting inflation back to the 2% target, the bank has tended to forecast price growth to be back to near target levels within a few years. Defenders of these forecasts would argue that the customary achievement of inflation that’s close to, if a bit below target justifies the way in which central banks have pitched on-target inflation rates over the long haul.

Right now, with inflation broadly seen around target in a few years, even by the Fed, where inflation is overshooting sharply, forecasters might still be ‘attracted’ to the Fed’s on-target inflation forecasts. If that implies a downward bias by forecasters and investors in the private sector then that could be particularly worrisome. For if the Fed, and other central banks are wrong, and inflation proves more persistent, the private sector will also be wrong in its assumption that inflation will fall back to target. And that, in turn, could mean significant market dislocation as forecasts adjust and the Fed (and others) lose some of the ‘anchor’ position that they have enjoyed for some years.

Mr. Steve Barrow expects this anchor to weaken as we examine private sector players that are further removed from the financial market as they probably take less notice of the Fed. Take US small businesses, for instance. The latest National Federation of Independent Business (NFIB) survey showed that nearly a half (44%) of firms plan to raise prices compared to those planning to cut. The last time the survey was this high was 1989; and is something that seems inconstant with inflation falling back to target in the way the Fed, private forecasters, and the market thinks.