Why Have Economists Continually Underestimated Projected Inflation?

I keep reading about how inflation has peaked (even peaked many months ago) and so any minute now the Fed will relent on raising interest rates, and will in fact start reducing them. Every data point that seems to support an early Fed pivot and a gentle “soft landing” for the economy is greeted with optimistic verbiage and a rip higher in stocks.

Except – – other meaningful data points regularly appear which show that inflation (especially core inflation) is remaining stubbornly high. The Personal Consumption Expenditures (PCE) Index is the Fed’s preferred way to track core inflation. It did peak in early 2022, and is falling, but very slowly and fitfully. Just when it seems like it is about to cascade downward, along comes another uptick.  The latest report for 02/24/23 showed the PCE index (excluding the volatile categories of food and energy) increasing 0.6 percent during the month of January, which translated to a 4.7 percent year-on-year gain. That was considerably higher than the 0.4 percent monthly gain (4.3 percent year-on-year) that economists expected.

Source: MV Financial

The chart below illustrates the chronic tendency of the economists at the Fed to lowball the estimates of future inflation. Each of the ten bars depicts quarterly projections of what inflation would be for 2023, starting back in September 2020 (first, green bar).  No one in the craziness of 2020 could be held particularly responsible back then for accurately projecting 2023 conditions. But the Fed embarrassed themselves badly into late 2021 by airily dismissing inflation as “transitory”, due mainly to supply chain constraints that would quickly pass. (See towards the middle of the chart, yellow Sept 2021 and blue Dec 2021 bars projecting a mere 2.2% inflation for 2023.)

Source: Jeremy LaKosh

Only as of December 2022 did estimates of inflation jump up to 3.1% for 2023, and that estimate will surely get revised upward even further.

Many factors probably went into this systematic failure on the part of the Fed economists. There are probably political reasons for erring on the rosy optimistic side, which I will not speculate on here.

One factor in particular was mentioned in the Minutes of the Jan 31/Feb 1 Fed meeting that I thought was significant:

A few participants remarked that some business contacts appeared keen to retain workers even in the face of slowing demand for output because of their recent experiences of labor shortages and hiring challenges.

Jeremy LaKosh notes regarding this feature, “If true across the economy, the idea of keeping employees for fear of facing the labor force shortage would represent a fundamental shift in the employment market. This shift would make it harder for wage increases to mitigate towards historical norms and keep upward pressure on prices.”

This all rings true to my anecdotal observations. In bygone days, when business slowed down, factories would lay off or furlough workers, with the expectation on all sides that they would call the workers back (and the workers would come back) when conditions improved. However, employers have had to struggle so hard this past year to find willing/able workers, that employers are loath to let them go, lest they never get them back. I have read that even though homebuilders are not sure they can sell the houses they are building, they are so worried about losing workers that they are keeping them on the payroll, building away.

Other inflation data points show big decreases in prices for goods (and energy), but not for services. Wages, of course, are the big driver for service costs.

So the inflation story in 2023 seems to come down largely to a labor shortage. This is a large topic cannot be fully addressed here. I will mention one factor for which I have anecdotal support, that the enormous benefits (stimulus money plus enhanced unemployment) paid out during 2020-2021 set up a large number of baby boomers to leave the workforce early and permanently. Studies show that this is a major factor in the drop in workforce participation rate post-Covid. Maybe some of those folks had not planned ahead of time for such early retirement, but they got a taste of the good life (NOT getting up and going to work every day) in 2020-2021 along with the extra cash to pad their savings, and so they decided to just not return to work. That exodus of trained and presumably productive workers has left a hole in the labor force which now manifests as a labor shortage, which drives up wages and therefore inflation and therefore interest rates, which will eventually crater the economy enough that struggling firms will finally lay off enough workers to mitigate wage gains.

I wonder if this unhappy scenario could be staved off with increased legal migration of targeted skilled workers from other countries to alleviate the labor shortage. Dunno, just a thought.

4 thoughts on “Why Have Economists Continually Underestimated Projected Inflation?

  1. StickerShockTrooper February 28, 2023 / 3:36 pm

    Did the Fed really “embarrass themselves” by calling inflation transitory in late 2021? It seems they would have been right had Russia not invade Ukraine, and I don’t think it’s fair to judge them on that.

    As for the massive stimulus packages, was there even enough historic data to predict how they would affect inflation? I thought those amounts were simply unprecedented.


    • Scott Buchanan March 1, 2023 / 9:30 am

      Thanks for your thoughtful comment.

      To the two points you mention – -First, Russia’s invasion of Ukraine led to a spike in commodities like oil, but that was short-lived and does not even feed directly into the PCE measure of inflation. As of today West Texas Intermediate prices are well below what they were before Feb 22, 2022. As noted in the article (and this was only something I realized as I was writing it) the main driver for the ongoing inflation is wages in the service industry, which is not something I think is particularly driven by the Ukraine situation.

      Second, agreed that there was not historic data for modelling exactly the effect of the feds/Fed blasting such an enormous amount of money into consumers’ wallets in such a short period of time. Yet it would have been reasonable to expect said monies to get spent over the next couple of years. With the lockdowns in 2020, services were largely shut down, so we went on a huge binge of buying “stuff”, largely made in China and shipped free if you had Amazon prime. But as of mid 2021 people were clearly chafing to be out and about and spending money on experiences and travel again, which would lead to a rebound in demand for services.

      There is certainly room for honest disagreement here, as to what the Fed *should have* known in say August 2021. I am too lazy to go searching for all of them now, but I do remember reading other voices warning back then that inflation was not going to be “transitory”, and calling out the Fed for its rosy projections. Here is one such voice: Analyst Joseph Wang, who formerly worked at the Fed’s Open Market trading desk, wrote Sept 27, 2021 https://fedguy.com/wealth-sideeffects/

      “…The “wealth effect” [[ from the pandemic windfall]] is thought to boost consumption, but common sense (and some evidence) suggests it would also impact the need and willingness to work. Household wealth has surged over the past quarters for broad segments of the public, with an overall increase of $5.8t just over 2021 Q2. Fiscal policy pumped $1.3t of cash onto household balance sheets, but the market gods have also made a hefty contribution. Over the past two years home prices nationwide rose 25%, the S&P 500 is up 45%, and crypto gains have changed many lives. At the same time, the labor participation rate is depressed, employees are resigning, and wages are rising. Older workers can now retire early, and many others have enough of a nest egg to walk away from work they don’t need. In this post we estimate the distribution of wealth increases, pencil in the missing crypto wealth, and suggest that the Fed may be running the economy much hotter than they realize…” – – and this is exactly what has happened.

      We also had the example from 2008-2009 recession, where a lot of folks who had been laid off got used to living at a lower standard (but not having to go to work) with the generous extended unemployment benefits, and then when those ran out they switched over to claiming disability benefits. (I knew several such folks, and may dedicate a blog post to this topic). All of which led to a long lasting step down in labor force participation.


  2. StickerShockTrooper March 1, 2023 / 7:54 pm

    Thanks for answering my question.

    I remember the latter-2021 period as a time of uncertainty between Russia’s military buildup, the continuing lockdown in China, and fears of new Covid variants (Delta? Omicron? I don’t even remember anymore.) So I can’t fault the Fed’s wait-and-see attitude, with the possibility of more shocks on the horizon. There was also the fear that people would just pocket their stimulus checks and hunker down for another year. Of course, hindsight is 20/20.


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