Inflation - Problems in Forecasting Inflation

Why is the rate of inflation difficult to forecast accurately?

The rate of inflation is one of the most important macroeconomic indicators that we study in macroeconomics. Data on prices is published regularly and given lots of attention by the media and the financial markets. Many agents be they businesses, households and governments would like to have accurate forecasts of what is likely to happen to prices in the future because they affect spending, saving and investment decisions.

Inflation is a difficult indicator to forecast accurately. Our chart below shows the UK CPI inflation forecast published by the Bank of England in their quarterly Inflation Report. Remember that the Bank of England has a mandate to control the rate of inflation so that CPI inflation remains close to the 2% target. The probability fan chart for inflation indicates the range of probabilities for inflation in the forecast period. Notice how wide is that range, there is much uncertainty about what is likely to happen to inflation in the UK. In 2014, there is the possibility of deflation (inflation of -1%) or inflation higher than 4%. The darker the shading, the higher the probability attached to the outcome.

Some reasons for difficulties in forecasting inflation

• Volatile global energy prices
• Changes in value of the currency
• Uncertain growth of aggregate demand
• Volatile food prices
• Government indirect taxes can change