Predicting inflation is a very important task for Economists. Future forecasts of inflation are used to determine current monetary policy. If inflation predictions are wrong it can cause inappropriate monetary policy, resulting in either inflation or recession. Although economists may look at various economic data, there is no foolproof method for predicting inflation. Generally speaking inflation is easier to predict and less volatile when inflation rates are low. As inflation increases it also becomes more volatile and harder to predict.
To predict inflation, economists will need to look at various economic data and decide whether inflationary pressures in the economy will be increasing or decreasing. The key factor here is the amount of spare capacity and the rate of economic growth.
Suppose an economy, such as the UK, has a long run trend rate of 2.5%. This means growth of 2.5% or less is unlikely to cause inflation. If however, growth is above 3 -4 % then the economy will quickly approach full capacity and therefore inflation is likely to occur.
Unemployment and Inflation Predictions
Some economists believe there is a trade off between unemployment and inflation. If unemployment falls it could be a sign that inflationary pressures will increase. As unemployment falls it gets harder to employ workers causing wage inflation. This wage inflation is likely to cause actual inflation.
However, sometimes unemployment can fall without causing inflation. For example, unemployment has fallen in the UK, without causing inflation. This may be due to a sustained reduction in the natural rate (structural unemployment) Nevertheless unemployment figures can be a guide to future inflation.
House Prices and Future Inflation.
It is often assumed that house price inflation will cause actual inflation. There is a good economic reason for this. If house prices are rising it creates a wealth effect. Rising wealth encourages consumer spending (equity withdrawal and higher confidence) this spending can then cause inflation. However, it doesn’t necessarily cause inflation. In the early 2000s, the UK had house price inflation of over 20%, but it didn’t cause actual inflation. There are many factors that affect inflation, not just house prices.
Money Supply and Inflation.
The quantity theory of money states that increased money supply will lead to inflation. This is because of the relationship between money supply and inflation, shown in the equation MV=PT where V and T are independent of the Money Supply. However, in practise empirical evidence has shown that increased money supply doesn’t necessarily cause inflation, as there are other factors determining money supply and inflation.
Hysteresis – What Happened in the Past?
It is argued that if you want the best prediction for inflation, ignore all the economists predictions and just state what happened last year. E.g. in 2007 the UK experienced inflation of 2.1%. Therefore the best prediction for inflation in 2007 is 2.1%. Of course, inflation does change from year to year, but it shows the difficulty of predicting inflation that it is often best to just use last years data.
However, there is an important point here and that is the role of expectations. If inflation is low, people will expect low inflation in the next year, workers will not demand big pay rises, firms will not try to increase prices. Therefore, low inflation becomes easier to maintain. If inflation is high then people will be expecting inflation in the next year. Therefore, it becomes difficult to remove inflation from the system (without pain like a recession)
Supply Side Shocks and Inflation.
When predicting inflation you can never take into account unexpected supply side shocks. For example, a rapid increase in oil price inflation would cause a significant rise in inflation.
My Predictions for Inflation in 2008
- Inflation UK 2008 2.1%
- Inflation 2008 US 2.3%
- Inflation 2008 China 4.1%
- Inflation 2008 India 8.5%
- Inflation 2008 Japan 1.2%
- Inflation 2008 EU 1.8%
Update – Nov 2008
Well of course, my predictions were wrong. CPI inflation in UK is currently over 5%. What happened was a rather unexpected cost push inflation – rising oil prices, rising food prices, rising electricity prices. However, with the global economy moving sharply into a recession, and oil prices falling back to 2007 levels, inflation is almost certain to fall in 2009. Thus this inflation spike has only proved temporary and has not really influenced people’s expectations. I am going to predict inflation for the end of 2009, and use exactly the same predictions as for 2008
UK Inflation 2009 – 2% (If lower interest rates fail to stimulate the economy, there is even danger of inflation slipping below the target and moving perilously close to deflation)