Forecasting Inflation-Surveys versus Other Forecasts

By Thomas, Lloyd B.; Grant, Alan P. | Business Economics, July 2000 | Go to article overview
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Forecasting Inflation-Surveys versus Other Forecasts

Thomas, Lloyd B., Grant, Alan P., Business Economics


Few forecasts are as common in business as forecasts for inflation. Surveys, time-series methods and structural econometric models are the most frequently used means for making such forecasts. In addition, it may be possible to infer future inflation forecasts from the behavior of financial markets. This study takes representative examples from each genre and makes a systematic comparison of how well they performed in the 1980s and 1990s. The results indicate that there is little difference between structural models and surveys. Both are markedly superior, however, to an ARIMA time series model and to inferences from financial markets. Thus, cost and other factors may be the major determinants in each firm's choice between structural models and surveys.

Inflation forecasts play a key role in numerous important business decisions. Management's forecast of inflation, in conjunction with the existing rate of interest, determines the expected real rate of interest. This expected or ex-ante real interest rate, in turn, influences decisions concerning business investment in plant, equipment, technology and inventories. Inflation expectations along with productivity growth are crucial in determining the magnitude of wage and benefit hikes that firms may prudently grant workers. Inflation expectations pertaining to the United States and foreign nations influence business decisions regarding the investment of financial capital at home and abroad. Such decisions impinge significantly on foreign exchange rates thereby triggering changes in export and import activity. Moreover, myriad household decisions are influenced by expected real interest rates, which hinge on the outlook for inflation. Mistakes in forecasting inflation can be quite costly to firms and individuals alike.

There exist several methods of drawing inferences on the magnitude of expected inflation. Several surveys of expected inflation are available today. Econometric models, both of the structural and a-theoretical time-series genres, are also widely used to provide forecasts of inflation. In addition, implicit forecasts of inflation can be derived from financial market phenomena. In this paper, we examine several types of inflation forecasts formulated in the last two decades of the twentieth century and subject them to tests for accuracy and unbiasedness. We evaluate one-year-ahead consumer price index (CPI) inflation forecasts formulated from the first quarter of 1980 through the fourth quarter of 1998 and use actual inflation experienced through the end of 1999 to evaluate the forecasts.

More specifically, we evaluate two major surveys of inflation expectations: the Livingston Survey of professional economists and the Michigan Survey of households. [1] Both an a-theoretical ARIMA model and a structural econometric model will provide benchmarks for evaluating the forecasting acumen of survey participants. Finally, we will examine inflation forecasts derived from two alternative formulations of Irving Fisher's well-known interest rate framework. [2]

Evaluating Two Survey Forecasts

Today, there are several surveys of inflation expectations available. Two of the most easily accessible and longest-standing surveys are the Livingston Survey of professional economists and the Michigan Survey of households. In this paper, we will examine these two forecasts.

Livingston Survey

Joseph Livingston, a Philadelphia financial journalist, initiated the Livingston forecasts in 1946. Livingston queried a sample of professional economists semiannually about their anticipations of the level of several key variables, including the CPI, approximately eight and fourteen months ahead. From such forecasts of the CPI, implicit inflation forecasts can be derived. In the June and December surveys conducted in the 1980s and 1990s, the number of economists in Livingston's sample varied from thirty-seven to sixty-three.

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