Inflation: How Not To Forecast Price Hikes

Correctly gauging the future is one way economists and investors measure their success. Both groups look for a statistical connection between current data and future trends. But sometimes what worked in the past no longer holds up.

That seems to the case with inflation expectations, as measured by the University of Michigan's Index of Consumer Sentiment and the actual experience of prices. Anthony Chan, senior economist at JPMorgan Fleming Asset Management (JPM ), studied the link between the consumers' mean forecast of inflation one year out and the reported consumer price index compiled by the Bureau of Labor Statistics. What he found was that expectations did a superb job of forecasting the CPI in the 1980s, explaining 86% of the change in the index. By the 1990s the forecast data could explain only one-third of the actual inflation. And in this decade expectations tell you almost nothing about how inflation will actually turn out. For example, before the runup in energy costs, consumers surveyed in late 2002 thought inflation in the coming year would run close to 3%. Instead, prices over the course of 2003 rose only 1.9%.

Do Consumers' Expectations Matter?
Consumers' inability to forecast the CPI correctly may seem odd given that, on a daily basis, they confront the price changes measured in the monthly BLS report. What's happening? Chan says consumers have not yet accepted that globalization and higher productivity have made the economy more inflation-resistant. That's true even though one piece of evidence on this new inflation resistance is consumers' own behavior. Chan points out that when shoppers face a higher price for a domestic good, they frequently switch to a cheaper import.

This study sends an important warning about blindly following rules of thumb that worked in the past. Because the link between inflation expectations and actual inflation was so strong in the 1980s, investors and economists have become used to relying on it to forecast inflation. Chan thinks the relationship will reassert itself as consumers adjust their thinking. But for now consumer expectations about prices seem to be ignoring the new economic order.

By Kathleen Madigan

    Before it's here, it's on the Bloomberg Terminal.