Inflation: low expectations set the stage for further surprise

When asked most of last year about price inflation’s sudden surge, central bankers often responded using the adjective “transitory”. Not any more.

Confirming that thesis is all but dead, the European Central Bank reported on Friday that consumer prices climbed in April by 7.5 per cent. That was the sixth consecutive new high recorded in Euroland. In the US and UK inflation was 8.5 per cent and 7 per cent respectively in March.

Moreover, a day previously the ECB issued a detailed mea culpa on the inaccuracy of its inflation predictions over the past two years. Its forecasts especially deviated from reality during the final quarter of 2021 when energy prices accelerated upwards. As the EU seriously considers an import ban on Russian oil, the risk for further forecast errors increases.

The ECB has underestimated inflation for the first quarter by a whopping 2 percentage points. Consider its forecasts made a year ago and that tracking error more than doubles to 5 percentage points.

Lex claims no high accuracy in forecasting either and, to be fair, the ECB were not alone. The Bank of England and the Federal Reserve both similarly miscalculated in their own respective forecasts. As the graph reveals, the ECB’s record on price predictions is patchy.

Blame any breakdown in predictive power on the erratic behaviour of financial markets. Even before the war in Ukraine, European natural gas prices in Europe had undergone seemingly puzzling surges. Growing correlation between wholesale and consumer prices suggests increases are more quickly passed on to end users, and in turn inflation measures.

Market expectations play a big role in inflation forecasting. From both surveys and financial indicators (such as interest rate movements) flow central bank predictions. It is possible that they are skewed by a decade of negligible inflation, reinforced by dovish central bank messaging. If so, inflation rates, which many believe have peaked, will continue to shoot past central bank predictions.

The Lex team is interested in hearing more from readers. Please tell us what you think of central bank inflation forecasting in the comments section below.