Although being in a downward trend, American inflation is still higher than the FED's target.

It would be an understatement to say that forecasting inflation has been difficult over the past year, or two. Habitual underestimation of inflation has been commonplace among governments, central banks, and private sector forecasters. Most now argue for inflation to fall, but could they be proved wrong again?

The focus on inflation, and how to forecast it, has rarely been as intense as it is now. That’s hardly surprising when inflation rose so much and so many were caught out. But in spite of the poor forecasting record, it seems as if financial markets are still putting their faith in the idea that inflation will not just fall, but will fall back to levels close to central bank targets.

For instance, if we look at five-year inflation swaps starting in five years, the current US and euro zone rates are in the vicinity of 2.5%. That’s not far from target at all and shows faith that, once all this pandemic-led and Ukraine/Russia-led inflation volatility disappears, inflation will be close to where central banks want it.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy thinks this is too optimistic on a couple of levels. The first is to do with the shorter term, and it relates to the fact that surveys of firms still show lots of price pressures in the pipeline. The second is a longer-term consideration, which is that structural forces were at work even before the pandemic to push inflation up, and all the pandemic (and the Ukraine conflict) have done is dramatically to accelerate these longer-term influences.

On the first of these, Mr. Steve Barrow took a lot of his views about the inflation process from business surveys during the pandemic and the Russia/Ukraine conflict. The reason being that, in such volatile times, we could not rely on consumer expectations, as many policymakers seemed to do, because consumers, for the most part, think that future inflation will simply echo the levels we’ve seen in the past. Hence the formation of higher inflation expectations is slow moving because consumers really have no idea where inflation will be in the future.

Businesses, however, see price changes far more quickly, and surveys reflect this. Hence, we’ve relied on surveys such as those from the CBI in the UK or the NFIB in the US where firms are not trying to predict the general level of inflation but are, instead, reporting how they see prices for their own inputs and outputs in the near future. Many of these surveys quickly showed back in 2020/21 that future price risks were much greater than anything we’d seen for many decades and, sure enough, inflation started to soar soon after.

The question now is whether these same surveys seem to support the idea of a rapid fall in inflation as forecast by policymakers. On this score, there has undoubtedly been some easing of price pressures but not, it would seem, to levels that are consistent with a return of inflation to target.

Business surveys can only help with short-term forecasts. Mr. Steve Barrow highlighted two structural factors that have been flashing warning signs about inflation since well before the pandemic. They are the two ‘Ds’: demographics and deglobalization. The former is reflected in declines in the working age population relative to those that have retired; a trend that has worsened because of the pandemic. Deglobalization has been around since before the pandemic, perhaps even as far back as the global financial crisis of 2008/09. This too has been put on steroids by supply chain problems and supply security concerns after the pandemic and Russia’s attempted invasion of Ukraine. These pressures are going to remain well after the recent surge in prices has washed out. Hence, in both a short term and a long-term context, there are reasons to fear that inflation won’t decline in the way that central banks expect, and many will just have to accept that 2% targets are now out of reach on anything other than a temporary basis.