Accounting, finance & control

Inflation forecasts are pointless

By Alfred Slager | April 1, 2022 | 3 min read
artikel-inflatie-alfred-slager

Inflation has risen faster than predicted in recent months. This is easily explained in hindsight, of course. The Covid pandemic brought our economy to a screeching halt, for instance. Once business began to recover, not everyone was sufficiently prepared. This led to shortages, resulting in higher prices. Less than two months ago, the situation seemed to relax. But the war in Ukraine subsequently caused new shortages in addition to human suffering. Inflation is rising even more strongly than previously forecast. What’s the point of forecasts, though, once we’re actually staring down the reality of rapidly rising inflation with an enormous impact? 

Rising energy prices

Other experts trace our current high inflation to a different phenomenon. Supplies of money and goods and services need to be in equilibrium, and these are currently badly imbalanced. When product prices are forced to increase, that’s just asking for the types of problems we’re seeing right now. If energy costs rise and the price of a TV goes up because there aren’t enough chips, employees will insist on higher wages during salary negotiations in order to maintain purchasing power. Businesses will then start raising prices to maintain profit margins in their turn. In this way, inflation increases in leaps and bounds.

Nobody knows what to do

Experts spend a lot of effort trying to predict inflation because the impact is so enormous, but the truth is, nobody really knows what to do. Scientific research has revealed that experts aren’t actually very good at forecasting. When, at the height of the 2008 financial crisis, the UK’s Queen Elizabeth asked renowned economists why they hadn’t predicted this, they didn’t have a good answer. 

Disruption: unexpected trend breaks

What we do know is that forecasters are good at following trends and making forecasts on that basis. However, for this method to work, the world around us has to be relatively stable. When sudden change, or disruption, upsets conditions badly, the consequences become unpredictable. In other words, experts can forecast trends, just not trend breaks.

Confidence intervals for climate change

In addition, while a degree of uncertainty is inherent to forecasting, this so-called confidence interval often isn’t clearly communicated. For example, climate change will cause temperatures to rise, but the associated confidence interval is low. A statement that temperatures will increase by 2 degrees Celsius, plus or minus a specific standard deviation for a certain period and with a few additional assumptions, is much harder to communicate. That’s why the people responsible for spreading the message choose to focus on those two degrees. And when that prediction subsequently proves inaccurate, we’re all oh so surprised. 

Modest profits by overconfident investors

People are also more likely to trust predictions if these are made by someone who exudes confidence. We believe experts must have thought things through much better than we could ourselves. Investors often appear very confident, and we’re happy to listen to them. However, the results of their investments can be a lot more modest than predicted. 

How can we anticipate the future?

In volatile times with continuing trend breaks, forecasts aren’t especially useful. In that case, what should economists, finance professionals and investors be doing to anticipate the future instead? Making decisions on that basis is their area of expertise, after all. Focus on the impact! Treat forecasting as an exercise in identifying correlations between factors and their effects: what are the driving forces behind changes in economic growth, business turnover or equity yields, and why? Apply these insights to the development of scenarios. Determine best, worst, and average case scenarios based on plausibility, then work out the business impact in detail.

Scenario-based strategic planning and decisions 

Make the scenario with the most negative implications your guiding scenario, the one you use to determine what must be done. Can the business handle the consequences if this scenario comes to pass? How would that go? Are there measures you can take to prepare in advance? In this way, you can already make various difficult decisions. This approach to strategic planning and decision-making, based on scenarios instead of forecasting, is still under development. It should improve options to include new behavioral insights and make quality decisions in times of great uncertainty and disruption. Will we ever abandon inflation forecasting altogether, though? That’s not very likely, because predicting is just too human!


This article originally appeared as a column by Prof. dr. Alfred Slager in CFO Magazine Belgium, January 2022.


 

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