When speaking about inflation forecasting, it’s important to set expectations. Forecasting is a notoriously difficult business; if I could do it well, then I wouldn’t be writing an article about it! However, modern economic theory posits that actual inflation crucially depends on expected future inflation. Indeed, Chairman Powell often cites the Fed’s assessment of inflation expectations in both his post-FOMC press conferences and testimony before Congress.
If expectations are, if fact, an important factor in the Fed’s decision-making process then investors must answer two important questions: 1) which measure(s) of inflation expectations to focus on and 2) what time horizon to use. The current Monetary Policy Report to the Congress indicates that policymakers regularly examine several measures of inflation expectations, including those of financial market participants, forecasts from staff economic models, the consensus of professional forecasters, and surveys of households and businesses. Time-horizon is of equal importance. Over shorter periods of time, realized inflation may evolve in response to factors exclusive to monetary policy (as COVID made us acutely aware).
In this post, I will review the performance of both short and long-term forecasts from consumers and economists for predicting future realized inflation. The goal is to better understand the relative accuracy and reliability of these forecasts as a means for gauging future realized inflation and, hopefully, shed light on the implications these measures have on the direction of monetary policy.
Data
Consumer expectations are based on the Survey of Consumers published by the University of Michigan. The survey, released monthly, provides data on expected inflation over the next 12-months and 5-years, offering both a short and long run perspective of the American public. Data for 12-month expectations is available on a monthly basis beginning in 1978. Data for 5-year expectations is spotty in the early years of the survey and for my purposes will start in 1990 when consistent monthly readings become available.
Economist expectations are taken from the Cleveland Fed’s Inflation Expectations model. The Cleveland Fed has published the results for 1-, 5- and 10-year expected inflation from this model going back to 1982. The model takes a range of input variables, including:
- Blue Chip CPI forecast
- Current month and historical CPI
- Short- and long-term Treasury yields
- Survey of Professional Forecasters median year-over-year CPI inflation rate
To measure inflation, I will use CPI and Core CPI, respectively. While CPI tends to be most relevant for consumers, policy makers tend to place greater emphasis on “core” statistics which are less volatile. The change in CPI and Core CPI will be presented on a year-over-year and 5-year annualized basis in order to facilitate a direct comparison with the expectations measures cited above.
Results I: 12-month Expectations v. Realized Inflation
The below charts depict the inflation expectations of the participants in the Univ. of Michigan survey (e.g., “Univ. Mich.”) and the inflation forecast from the Cleveland Fed (i.e., “economists”) for the next 12-months against the realized year-over-year (YoY) change in CPI and Core CPI, respectively. More specifically, the YoY change in CPI/Core CPI has been lagged by 12-months to show what inflation actually ended up being in the succeeding year. Presented this way, we can clearly see what consumers/economists predicted inflation to be at a point in time and what the official result was standing at that point in time and looking 12-months into the future.
A quick scan of the plots suggests that neither economist nor consumer estimates track future inflation especially well. With respect to CPI, periods of divergence between realized and expected values dominate the plot. There does appear to be some improvement when moving from CPI to Core CPI. In particular, the mid-90’s shows a relatively high degree of alignment among the series. More recently, economists seem to have done a decent job forecasting the average level of inflation during the 2010’s; albeit with much higher volatility than Core CPI.
Other interesting features of the plots include the observation that since ~2000 consumer expectations of inflation have been consistently higher than economist estimates. Moreover, consumer expectations ran markedly higher than both realized CPI and Core CPI throughout the 2010’s. In general, consumers and economists both significantly underestimated the post-pandemic inflation surge.
To confirm the accuracy of these intuitive statements, the below plot depicts the rolling 3-year correlation between our forecast measures and realized inflation.
While the chart shows a fair degree of correlation between CPI/Core CPI and the expectations measures during the 90’s, the salient feature is that the correlations are wide ranging and highly unstable. Indeed, the 2010’s period shows considerable degradation in the relationship across all measures with negative correlation occurring more often that positive. This implies an element of confusion amongst both consumers and economists concerning even the direction of inflation.
To further gauge the accuracy of these forecasts, the below table shows the root mean-squared error and R2 from regressions of the forecasting variables against CPI and Core CPI, respectively. The standard deviations for CPI and Core CPI are also noted.
Table 1: Sample Statistics & Forecast Accuracy for 12-month Inflation & Inflation Expectations
| CPI | Core CPI | |
| Standard Deviation | .0159 | .0127 |
| RMSE | Adjusted-R2 | |
| Economists v. CPI | .0154 | 7.5% |
| Univ. Mich. v. CPI | .0156 | 5.0% |
| Economists v. Core CPI | .0098 | 39.7% |
| Univ. Mich. v. Core CPI | .0110 | 24.4% |
If economist estimates and survey responses from consumers are good predictors of future inflation, then we would anticipate high adjusted-R2’s and for regression RMSE’s to be notably below the standard deviations of CPI/Core CPI. From Table 1 we can see that neither economists nor consumers are especially capable at forecasting 12-month CPI. RMSE’s are nearly the same as the standard deviation of CPI and adjusted-R2’s are very low; indicating that the regressors don’t explain much of the year-to-year variation. When we move to evaluate Core CPI, we observe significant improvement for both measures. Approximately, 40% of the variation in Core CPI is explained by the economist prediction and RMSE is meaningfully lower. The statistics for the Univ. of Michigan survey are similarly improved; though, economists appear to have the edge. The lower overall variance of the Core CPI seems to aid both groups in predicting 12-month forward inflation.
Results II: 5-Year Expectations v. Realized Inflation
As noted in the introduction, short-run inflation may be influenced by factors substantially outside of the control of monetary policy. Therefore, “short-run” factors may make near horizon forecasting difficult. However, in the long-run, inflation is primarily driven by monetary factors. Consumers and economists may have an easier time predicting long-run inflation as short-term fluctuations in the price level “even out”. To evaluate this hypothesis, we can perform a similar exercise as Part 1 for a 5-year horizon.
In this section, I will be evaluating the 5-year annualized change in inflation against the 5-year forecast from the Cleveland Fed and responses from the Michigan survey, respectively. Let’s begin with the charts:
Once again, the charts depict substantial discrepancies between the forecast variables and both headline and core inflation statistics. The Economist estimate is, at least, directionally accurate to the extent that it declined for the better part of 30 years in line with inflation. The estimate from the Michigan survey has been consistently above CPI and Core CPI and does not capture the changes in inflation well. In the charts, the last reading for the forecast variables was taken in July 2018 (hence predicting inflation for July 2023). It’s no surprise then that both measures missed the run up in inflation taking place in 2022 and 2023.
The rolling correlation plot confirms some of these informal observations. The Economist estimate has generally been only weakly correlated with CPI over the last ~15 years. The most striking result is how poorly correlated the University of Michigan survey has been with both measures, posting a deeply negative correlation for the better part of 20 years. Indeed, the rolling correlations plots are not suggestive of any kind of a stable relationship between expectations and realized inflation.
Table 2 presents the sample and forecast accuracy statistics.
Table 2: Sample Statistics & Forecast Accuracy for 5-Year Inflation & Inflation Expectations
| CPI | Core CPI | |
| Standard Deviation | .0061 | .0048 |
| RMSE | Adjusted-R2 | |
| Economists v. CPI | .0056 | 16.6% |
| Univ. Mich. v. CPI | .0061 | 1.1% |
| Economists v. Core CPI | .0042 | 23.6% |
| Univ. Mich. v. Core CPI | .0043 | 20.4% |
For the Economist estimates, the summary statistics demonstrate only a modest ability to predict 5-year inflation. The R2 for 5-year CPI is higher than the R2 obtained from the earlier 12-month regression. This implies that the longer time horizon is moderately beneficial for economist’s structural models. The Michigan survey seemingly has no meaningful relationship with CPI, but the statistics do improve for Core CPI and are broadly in line with the results reached for Economists v. Core CPI. Ultimately, the regressions do not support the hypothesis that long-run inflation is easier to forecast. In fact, the performance deteriorates in several cases.
Concluding Remarks
Modern economic theory suggests that managing expectations is a key for containing inflation. In this post, I measured the performance of economist and consumer forecasts for predicting future realized inflation over the short and long-run. The results mostly suggest that neither economists nor consumers are able to forecast inflation with a high or consistent degree of accuracy. On balance, economists fair better than consumers, but their relatively superior reliability is still quite limited and confined primarily to short-run, Core CPI.
There are many alteratives for measuring inflation (PCE, median CPI, “sticky” indices, etc.) and expectations (market based, business surveys, etc.) and even more when in comes to forecasting. However, the foregoing analysis is based on some of the more popular and widely publicized measures and casts considerable doubt on the enterprise.
Forecasting…it’s a tricky business!
