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While the central banks continue to wrestle inflation to ground, economists are asking two basic questions: why didn’t the central bankers see this inflation coming? And, why didn’t those same bankers see inflation rise so high and so quickly? A recent research paper by the staff at the Bank of Canada (BOC) offers some answers to these two vexing questions.

Before, we get into these explanations, let's see just how far off the mark were central bankers’ forecasts. All central banks employ a variety of economic forecasting models to guide their rate decision-making. The purpose of economic models is to capture turning points in various sectors of the economy in response to shocks to the system, such as the pandemic and the Russian invasion of Ukraine. Moreover, successful forecasting requires continuous updating as incoming data shed light on economic performance. If one wants to forecast successfully, then forecast often.

Chart 1 depicts the series of inflation forecasts adopted by the BOC over the period of January 2020, the start of the pandemic, to October 2022. While efforts were made to update forecasts continuously, the BOC never got it right. It consistently underestimated the rate of change in consumer prices and, and its duration, that is how long high inflation rates persisted. Initially, central bankers spoke of inflation as ‘transitory’ and argued that there was no need to raise rates sharply. Early in the pandemic, inflation was expected to return to the 2% target by early 2022. However, as inflation continued its upward climb, the 2% target date was pushed further and further into the future. The current expectations put the return to a 2% rate out to early 2024. Given the past failures to forecast inflation accurately, no wonder there is skepticism regarding when the 2% inflation target will be reached.

Chart 1 The Changes in the BOC Forecasts

The BOC was not alone in this regard. The Bank of England and European Central Bank had also underpredicted inflation. More to the point, the central banks’ forecasting errors were significantly large, especially in the early days of the pandemic through 2021.

Chart 2 Inflation Projection Errors

So, why were the central banks caught so far off guard?  

The BOC researchers argued that inflation surged largely triggered by the pandemic. The economic models referred to earlier were not able to capture the influence of a worldwide pandemic on demand and supply. Simply put, there is no applicable historical data that forecasters could rely upon in building their models.

The researchers stress “the disruption in economic activity was uneven across sectors.” Goods producing sectors, especially those manufactured overseas, and housing experienced rapid and steep price increases. Economic forecasters have a very tough time factoring into the effects of war, especially on energy and food supplies, and the Russian invasion was no exception. On top of everything was the Chinese on-again, off-again lockdown policy which added to the existing disruptions in the supply of manufactured goods. 

These insights help us in understanding why central bankers did not see what was coming. However, we are left with the unsettled feeling that we cannot forecast confidently when we can expect to reach our inflation targets.

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