Revision: Problems in Forecasting Inflation

Inflation can never be forecast with perfect accuracy! For a start, the published inflation measure is the result of millions of pricing decisions made by businesses large and small operating in thousands of different markets and sub-markets. The calculation of the consumer price index in the UK although extremely thorough, is always subject to error and omission.

External shocks can make forecasts inaccurate. For example, a jump in world oil prices or the falls in global share prices have feedback effects through the economic system.

The exchange rate can fluctuate leading to volatile import prices – for example the pound fell by more than 20% against the Euro during the course of 2007-08.

The Bank of England in its quarterly Inflation Report produces a colourful ‘fan-chart’ which encompasses its central forecast for inflation based on the probabilities of inflation falling within certain ranges over the next two years. The central projection is always that the inflation target will be met. But it could not be otherwise, for if the Bank was to say that its current interest rates were not appropriate to meeting the inflation target going forward, and then a change in policy would be required!