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

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by Mish Shedlock, The Street:

“Inflation models are worse than useless. They make central banks complacent.”

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.

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Inflation Models and Forecasts

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?

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