Great expectations

November 27, 2009 in Economics,Math

I've previously covered the danger of attributing meaning to a forecast which is obviously based on little or no information. In that case, it was the manufacturing survey, which one might dismiss as a more obscure measure. Recently, however, Ken Houghton has written a pair of posts on inflation forecasts that bring me back to that argument.

In his first, he presents a study that seems to show that, indeed, inflation expectations tend to assume that the future will look just like the present:

Again, this does not surprise me, as the futre expectation of a random walk is its present value. In the second post, the time series of inflation vs expectations is presented:

With the additional dimension of time, I can see a simple heuristic for inflation expectations: consumers think that inflation will stay at roughly the same level that it is on any given day, with some slight reversion to the Fed target, unless inflation is currently below the target, in which case they think it will rapidly bounce back to - or above - that level.

You can see the inflationary spikes in 2006 echoed in the 2007 forecast; the sharp 2008 increase and subsequent fall are mirrored in the 2009 forecast for the time they remain above the target, at which point they halt their slide.

These  charts tell me two things. First, that consumers have very little insight into future inflation levels, to the point that they are unwilling to even choose a simple number like 3% and prefer instead to say that the future level will be similar to today's. Second, that consumers have blind faith in the Fed's ability to keep inflation at or above its target level - even in the face of evidence against that power.

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