Forecasting inflation is challenging, but setting expectations is essential. If expectations influence the Fed’s decision-making process, then investors need to know what inflation expectation metrics to focus on and what their time horizon should be. Policymakers examine inflation expectation measures from financial market participants, staff economic models, consensus of professional forecasters, and surveys of households and businesses. Expectations over shorter time periods may be influenced by non-monetary factors, as observed during the pandemic. Therefore, it’s important to evaluate the accuracy of short- and long-term inflation forecasts.
The University of Michigan’s Survey of Consumers and the Federal Reserve Bank of Cleveland’s Inflation Expectations model are used to analyze consumer and economist inflation expectations. The analysis focuses on CPI and Core CPI inflation metrics.
The results show that neither economist nor consumer estimates accurately tracked future inflation, with diverging realized and expected values dominating the plots. Consumer inflation expectations have consistently been higher than those of economists since around 2000. During the 1990s, there was some correlation between forecasts and realized inflation, but the relationship has been highly unstable, with more negative than positive correlations during the 2010s.
The analysis also evaluates five-year forecasts and finds that forecast variables and inflation statistics show considerable divergence. While the Cleveland Fed estimate declined with inflation for the better part of 30 years, the University of Michigan survey estimates consistently exceeded CPI and Core CPI. The rolling correlation plots and sample statistics also demonstrate that long-term inflation forecasting is challenging.
In conclusion, the analysis suggests that the most common metrics fail to predict inflation with any certainty, casting considerable doubt on the utility of inflation forecasting altogether. The data implies that managing inflation expectations is critical to keeping inflation in check, but economist and consumer expectations of future inflation have proven widely off the mark over the short and long run.
