Inflation is the enemy of bonds. Higher inflation leads to lower real rates of returns on a fixed rate bond and so the accurate forecasting of inflation is critical to successful long term bond investing. Insurance companies, life offices, pension funds, governments and many other organisations rely on inflation forecasts to budget for the future. Central banks in particular need to accurately assess the future rate of inflation in their monetary policy settings and its implications for economic growth.
Forecasting inflation is a notoriously difficult task and there are a multitude of measures taken into account when making that assessment. The RBA has released an academic discussion paper on the process that focuses on the disagreements surrounding methodology and expectations between forecasters and consumers.
The expectations of professional forecasters such as market economists could be considered to be the most relevant, because professionals are able to put significant resources into understanding the likely path of inflation. However, consumer and union measures provide information on the expectations embedded in wage negotiations and other cost inputs, thereby influencing the trend rate of inflation.
An abstract of the paper shows that average and median measures of inflation expectations can disguise substantial disagreement in expectations. Disagreement in expectations has important implications for anchoring of inflation expectations and central bank credibility. The RBA uses individual response data from five survey measures of inflation expectations to document five features of disagreement about inflation expectations in Australia:
- there has been a decline in disagreement since the introduction of inflation targeting, except among consumers;
- disagreement responds little to most macroeconomic news surprises;
- disagreement among consumers is much larger than among professional forecasters;
- disagreement and the mean level of inflation expectations co-move for consumers but not professional forecasters;
- there appear to be persistent differences in consumer inflation expectations across different demographic groups. For professional forecasters, the reduction in the overall level of disagreement and unresponsiveness of disagreement to most macroeconomic news surprises is consistent with well-anchored inflation expectations.