Longer-Term Inflation Forecasts Are Less Accurate

The accuracy of inflation forecasts decreases the further out in the future economists make them for.

The accuracy of inflation forecasts decreases the further out in the future economists make them for. Not surprisingly, as the forecast horizon draws to close, inflation forecasts more closely mirror the actual economic data.

This pattern occurs in advanced and emerging market countries. The magnitude of error is greater in emerging and developing countries. Economists are also more likely to under-predict inflation in emerging and developing countries. Such countries have historically incurred many episodes of volatile inflation along with more periods of hyperinflation.

There are also lags in how long it takes for new information to be reflected in forecasts. Inflation forecasts for advanced economies take between approximately four and six weeks to fully incorporate new data. The lag for emerging market country forecasts is closer to six to eight weeks.

Two factors have influence. Economists, like others, tend to base their expectations (“anchor”) on past information and then make adjustments. This behavior often leads to insufficient adjustments. The second factor is “smoothing.” A revision made in one direction (up or down) tends to be followed by further revisions in the same direction. Study author João Tovar Jalles found “a clear tendency for ‘forecast smoothing’” in his analysis.

Jalles further looked specifically at recessionary and recovery periods. Over the 24-month horizon leading up to recessionary periods, inflation forecasts for advanced economies tended to overestimate the rate of inflation. The opposite was true for emerging and developing countries, with inflation being underestimated. Economists fail to anticipate an economic slowdown in the calendar year before it occurs and they tend to display a significant upward bias in their year-ahead April forecasts.

The average errors of inflation forecasts tend to be even larger during economic recoveries. Even compared to recessions, such forecasts tend to be more inaccurate. “Moreover, during recoveries, most forecasters revise downward their inflation predictions for advanced economies, but revise them upward for emerging and developing countries.” Jalles further observed “a much higher sense” of pessimism among advance economy forecasters for periods of up to one year following the end of a recession.

“On the Rationality and Efficiency of Inflation Forecasts: Evidence From Advanced and Emerging Market Economies,” João Tovar Jalles, Research in International Business and Finance accepted manuscript.