Opinion: Why did hardly anyone see inflation coming?

CAMBRIDGE, Mass. (Project Syndicate)—In 2008, as the global financial crisis ravaged economies around the world, Queen Elizabeth II, visiting the London School of Economics, asked, “Why didn’t anyone see it coming? High inflation in 2021 – particularly in the United States, where annual consumer price inflation hit a four-decade high of 7% in December – should prompt the same question.

Inflation is not as bad as a financial crisis, especially when price increases coincide with a rapidly improving economy. And while financial crises can be inherently unpredictable, forecasting inflation is an essential part of macroeconomic modelling.

To think that a stimulus of this magnitude would not cause inflation, one had to believe either that such a large adjustment was possible in a few months, or that fiscal policy was ineffective and did not increase aggregate demand. Both views are implausible.

miss the target

Why, then, was almost everyone so wrong about the US inflation story last year? A May survey of 36 private sector forecasters revealed a median inflation forecast of 2.3% for 2021 (as measured by the basic personal consumption expenditure price index, the de facto target indicator for Federal Reserve). Overall, the group put a 0.5% probability on inflation above 4% last year, but, according to the core PCE measure, it should be 4.5%.

But the most important forecasting lesson from the past year is humility.

The Federal Open Market Committee responsible for setting Fed rates fared no better, with none of its 18 members expecting inflation above 2.5% in 2021. Financial markets also appear to have missed this one. ci, bond prices giving similar predictions. Ditto for the International Monetary Fund, the Congressional Budget Office, President Joe Biden’s administration, and even many conservative economists.

Some of these collective errors resulted from developments that forecasters did not or could not expect. Fed Chairman Jerome Powell, among many others, has blamed the Delta variant of the coronavirus for slowing the reopening of the economy and therefore driving up inflation. But Powell and others had previously argued that the rise in inflation in the spring of 2021 was spurred by a fast reopened because vaccination reduced the number of cases.

Both of these excuses are unlikely to be correct. The emergence of Delta, like the pandemic in 2020, likely kept inflation lower than it otherwise would have been.


Supply disruptions

Supply chain disruptions were another unforeseen development that would have sent inflation forecasts skyrocketing. But while the pandemic has caused real bottlenecks in production networks, most are producing significantly more than last year, with US and global manufacturing output and shipping strongly.

This brings us to a bigger source of forecast error: not taking our economic models seriously enough. Forecasts based on extrapolation from the recent past are almost always as good as or even better than those based on more sophisticated modeling. The exception is when there are economic inputs that are well outside the realm of recent experience. For example, the extraordinary $2.5 trillion fiscal support to the US economy in 2021, representing 11% of gross domestic product, was far larger than any previous fiscal package since World War II.

A simple fiscal multiplier model would have predicted that average output in the last three quarters of 2021 would be 2% to 5% above pre-pandemic potential estimates. To think that a stimulus of this magnitude would not cause inflation, one had to believe either that such a large adjustment was possible in a few months, or that fiscal policy was ineffective and did not increase aggregate demand. Both views are implausible.

The economic models also gave us substantial reason to believe that several factors would reduce the potential of the U.S. economy in 2021. These included premature deaths, reduced immigration, lost capital investment, costs of hardening of the economy to COVID-19, pandemic-induced outflows from the workforce, and all the difficulties of rapidly reassembling an economy that had been torn apart. These constraints made it very likely that additional demand would push inflation even higher.

The job offer

A final set of errors occurred because our models lacked key inputs or interpretations. Since people relied on economic models, they often used a Phillips curve to predict inflation or changes in inflation with the unemployment rate. But those executives struggled to factor in the fact that the natural unemployment rate has likely increased, at least temporarily, due to the COVID-19 crisis.

More importantly, unemployment is not the only way to measure economic downturn. Pre-pandemic estimates show that the “quit rate” and the ratio of unemployed to job vacancies are better predictors of wage and price inflation. These other underemployment indicators were already stretched at the start of 2021 and were very stretched in the spring.

Looking back, the mental model I find most useful for thinking about 2021 is to apply fiscal multipliers to nominal GDP, use them to predict how much of the fiscal stimulus will be spent, then try to predict real GDP by understanding what is the production capacity of the economy. The difference between the two is inflation.

The multipliers indicated that total spending in 2021 would increase a lot, while the production constraints suggested that production would not increase as much. The difference was higher than expected inflation.

What awaits us

Where does this leave us in understanding inflation in 2022? Instead of making inertial predictions that the future will look like the past, taking our models seriously means factoring in high levels of demand, persistent supply constraints, and increasingly tight labor markets with wages rapidly rising nominal rates and higher inflation expectations. Some types of inflation, notably goods price inflation, are expected to decline this year, but others, including services inflation, are expected to rise.

So I expect another year of significant inflation, maybe not as high as 2021 but likely in the 3-4% range. But the most important forecasting lesson from the past year is humility. We should all add large margins of error around our expectations and be prepared to update our outlook as the economic situation evolves.

Jason Furman, professor of economic policy practice at Harvard Kennedy School and senior fellow at the Peterson Institute for International Economics, is a former chairman of President Barack Obama’s Council of Economic Advisers.

More views on inflation

Rex nut: Why Interest Rates Aren’t Really the Right Tool for Controlling Inflation

Pierre Morici: Why wait? The Federal Reserve should raise interest rates now

Otmar Issing: Stop Adding Fuel to the Fire of Inflation with Easy Money Policies

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