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How Bad are Inflation Models, Expectations, and Forecasts vs Reality?

"Inflation models are worse than useless. They make central banks complacent."
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Inflation Models and Forecasts

The Porcupine Flips

In The Porcupine Flips, Eurointelligence provides amusing as well as accurate statements about the ECB's inflation models. The same applies to the US, even more so. 

If anyone wonders why the pandemic models have been hopelessly wrong, just take a look at inflation models. Pandemic models are actually not too bad by comparison. Sure, they are wrong most of the time, but they are wrong in the normal sense in which models are wrong. They are sometimes too pessimistic, sometimes too optimistic.

Macroeconomic inflation models have the unique distinction of being wrong and biased. They perform worse than all of the following: a random number generator, a soothsayer with big ball, and a monkey with a dartboard. I am not suggesting that central banks should replace staff economists with monkeys. But if they did, the first thing we would note is a measurable reduction in forecasting bias. Wrong and unbiased is better than wrong and biased.

Our graph above is a stylised version of what has happened in the euro area, and what I expect to happen. The left side is nicknamed the porcupine chart, with the dotted lines representing the forecasts at various times, the blue line the rate of inflation, and the red line the inflation target. Note that the forecasts always erred in the same direction. This is because the inflation models are hardwired to predict inflation to revert to ECB's 2% target. It is an example of policy bias. If you predicted some other number, you would indirectly acknowledge that your policy is wrong.

Apart from policy bias, there is another important reason why central bank forecasting models perform so poorly. The models are not built for an inherently unstable environment, like our global economy since the financial crisis. The models have no way of dealing with financial shocks, pandemics and global supply chain shocks with persistent effects. Shocks do exist in those models, but their long-term net effect is zero. The 1970s do not exist in those models. Stagflation is impossible. The world of those models is a parallel universe.

If weather models performed similarly poorly, they would have been discarded a long time ago. But economists and central banks have invested so much into these models that the action of discarding them would imply a loss of face. Central banks cling to a strange definition of credibility. They are not the people who say: we tried it. It did not work. We are now going to try something else. Like a gambler facing ruin, they double down.

The intellectually lazy central banker relies on models that explain a world of unknown unknowns with known knowns.

That is one of the best columns Wolfgang Münchau has ever written, if not the best. 

Readers know I have been hounding the Fed and its ridiculous models for years. 

Fed Models 

  1. Phillips Curve
  2. Inflation Expectations 
  3. Consumer Spending Expectations

The Fed models all of those things and more. It places great weight on models that are both  logically and proven nonsense.

In Search of the Phillips Curve

In search of the Phillips Curve

Regarding point 1, Yet Another Fed Study Concludes Phillips Curve is Nonsense

Previously I noted that a Fed Study Shows Phillips Curve Is Useless. Yet, economists keep trying.

Both studies were done by Fed staffers. 

Yet, Fed Chairs Janet Yellen and Jerome Powell did not believe the Fed's own study. 

in March of 2017, Janet Yellen commented the "Phillips Curve is Alive“.

Fed presidents continue to believe their own academic training on the model, proven not to work in practice.

Mercy Me! Inflation Expectations Are No Longer Well Anchored

Inflation Expectations vs Year-Over-Year Inflation Measures Detail 2021-07

On July 14, 2021, I commented Mercy Me! Inflation Expectations Are No Longer Well Anchored

For most of eight years reported inflation was under 2% and often under 1%, and briefly negative. Yet, the look ahead median point prediction was never below 2.9%.

If expectations mattered, why did the CPI and PCE stay below 2% so long? 

Inflation Expectations vs Year-Over-Year Inflation Measures 2021-07

Expectations Fantasy

  • For most of 8 consecutive years, year-over-year CPI and PCE was under 2%.
  • In that same time frame, the Median 3-year estimate and the median point projections was seldom below 3%.
  • If inflation expectations mattered, that chart would be impossible.
  • Alternatively, one might say people believe low inflation is transitory.
  • Yet, we constantly hear the Fed yapping "Inflation expectations are well anchored".

Elastic vs Inelastic Demand

CPI Percentage Weights Elastic and Inelastic

I highlighted inelastic items.

Perhaps a portion of education is elastic. But a portion of other housing is inelastic as is a portion of communication and other goods.

Recreation is elastic and so is apparel (assuming one does not ruin one's only coat or shoes).

Somewhere between 80% and 90% of household purchases are inelastic.

Yet, the Fed is fully 100% committed to belief in inflation expectations. 

Inelastic Item Questions

Q: If consumers think the price of food will drop, will they stop eating? Will they eat twice as much if they expect prices will rise?

Q: If consumers think the price of gas will drop, will they stop driving?

Q: If consumers think the price of rent will drop, will they hold off renting until that happens? Will they rent two apartments if they expect the price to rise?

Asset prices are a different matter, however.

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Asset Price Expectations

  • People do buy stocks it they believe prices will rise. They avoid stocks or sell them if they expect prices will drop.
  • People will stretch to buy a home if they expect prices to rise. They wait if they expect prices will drop.

Note that every member of the Fed talks about expectations that don't matter ignoring those that do matter.

And not only does the Fed ignore asset price expectations, they ignore asset prices totally. That's how you get three enormous bubbles in 20 years.

A Fed Economist Concludes the Widely Believed Inflations Expectations Theory is Nonsense

On October 1, 2021, I noted A Fed Economist Concludes the Widely Believed Inflations Expectations Theory is Nonsense

Here are some excerpts from the actual study: 

The direct evidence for an expected inflation channel was never very strong. Most empirical tests concerned themselves with the proposition that there was no permanent Phillips curve tradeoff, in the sense that the coefficients on lagged inflation in an inflation equation summed to one.

In addition, most standard tests of the new-Keynesian Phillips curve suffer from such severe potential misspecification issues or such profound weak identification problems as to provide no evidence one way or the other regarding the importance of expectations (much the same statement applies to empirical tests that use survey measures of expected inflation).

What little we know about firms’ price-setting behavior suggests that many tend to respond to cost increases only when they actually show up and are visible to their customers, rather than in a preemptive fashion.

It is far, far better and much safer to have a firm anchor in nonsense than to put out on the troubled seas of thought. John Kenneth Galbraith (1958). 

Few things are harder to put up with than the annoyance of a good example. Mark Twain, The Tragedy of Pudd’nhead Wilson (1894)

Fed Group Think

Fed Chair Jerome Powell is a total believer in inflation expectations. So were previous Fed Chairs Janet Yellen and Ben Bernanke.

It is all part of the groupthink nature of the Fed.

Well Anchored Nonsense

Please recall my August 31, 2020 post The Fed's Stupidity is Still Well Anchored.

Former Fed chairs Janet Yellen and Ben Bernanke were both big Phillips Curve advocates despite the fact the theory never worked even according to Fed studies.

Every Fed Chair since at least Greenspan believes in inflation expectations.

I was unaware of John Kenneth Galbraith's 1958 statement "It is far, far better and much safer to have a firm anchor in nonsense than to put out on the troubled seas of thought," when I made my comment "Stupidity is well anchored." 

Lacy Hunt on Economic Models 

I discussed economic models with Lacy Hunt in two recent interviews.

Snips From #4

At one point I accidentally stated housing is over 30% of GDP. I meant to say CPI (consumer prices) not GDP. In a following sentence I did correct to consumer prices. 

Here are a couple of snips.

Mish: Lacy let's kick this off with inflation expectations. Ben Bernanke, Greenspan, Powell have this model. ... So much of consumer spending is actually not discretionary. So where do they get this idea that what people think will happen actually matters. What do you think about inflation expectations Lacy?

Lacy: It's not really possible to measure inflation expectations. I said that in the prior interview. You have to look at the fundamentals over a longer period of time, 2, 3, 5, years. And you basically have to take a very rational approach. You cannot extrapolate the current trends in inflation. And you need to ask yourself what determines inflation. ....

Mish for President of the Dallas Fed

On November 18, I threw my hat into the ring with this spoof regarding an opening at the Fed: Mish for President of the Dallas Fed

I did send that to the committee, promising to work on ending the Fed.

Many people nominated me as well and a dozen or so got thanks from the committee for my name.

Thanks for Tuning In!

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