Long-term economic forecasting can be very difficult. A well known joke by John Kenneth Galbraith is:
“The only function of economic forecasting is to make astrology look respectable.”
However, although there is some truth in this wisecrack, in the short term, we can be reasonably confident about predictions for inflation.
In particular, if we see a rise in input prices (raw materials), then there is a very strong correlation between these input prices and later rises in consumer price index.
Sharp rise in Markit/CIPS manufacturing input prices balance in October suggests CPI inflation set to pick up sharply over next few quarters pic.twitter.com/RimvHrEmpT
— Capital Economics (@CapEconUK) November 1, 2016
With some minor variations, we can see consumer prices tend to follow very closely changes in input prices. This graph also shows the recent rapid rise in input prices. Rising input prices in the UK are caused by the depreciation in the Pound causing imported raw materials to be more expensive. This rise in input prices will inevitably lead to a higher CPI.
The simple logic is that if firms see a rise in the costs of production, they will tend to pass these onto consumers in the form of higher prices.
It is possible, firms could try to absorb higher input prices with lower profit margins, but they are unlikely to do this.
- Higher input prices affect all manufacturers.
- Demand will be highly inelastic
- Firms need to charge higher prices to buy future raw materials.
Input prices to inflation
Therefore, if we have some event which leads to a change in input prices, we can be fairly confident of predicting the inflationary impact over the next six months.
This kind of input price inflation (or cost-push inflation) could be due to:
- Rising oil prices
- Depreciation in currency, which leads to rising import prices.
The UK has recently experienced a sharp depreciation in the Pound of up to 15%. As manufacturers import a high percentage of raw materials, this will quickly feed through into higher factory gate prices and later consumer prices.
A previous example of how depreciation in the Pound caused inflation. Producer inflation increased in early 2011 causing inflation CPI to reach over 5%.
Producer prices are what we call a leading indicator. It is data which will gives an insight into future economic prices.
Producer prices include:
- Input prices (price of raw materials)
- Output prices (factory gate prices) Prices manufacturers sell to retailers or other manufacturers.
Producer prices index at ONS
Bank of England inflation fan chart
This is the Bank of England’s fan chart for inflation in August 2016. It shows the Banks predictions for inflation over the next few years..
It is quite likely that in their next inflation prediction in November, they will increase their predictions for future inflation.
Explaining fan chart
The dark red indicates the most likely probability of inflation rates. The lighter red indicates a lower probability.
- In the short-term, the bank are confident inflation will be within a narrow range
- In the longer-term, the bank are less confident of predicting inflation – there is a bigger range of possible inflation rates – which is why the fan becomes wider.
Why is inflation harder to predict in medium term?
- Predicting exchange rates or oil prices becomes difficult for a year hence.
- There is a wider possibility of unexpected events to start influencing inflation –
- Demand side factors are harder to predict, e.g. how much will wages rise? how much will the depreciation in the Pound improve exports?
- Expectations of inflation could start to change in a years time.