Does past inflation predict the future?
Forecasts of non-tradables inflation have been produced using Phillips curves, where capacity pressure and inflation expectations have been the key drivers. The Bank had previously used the survey of 2-year ahead inflation expectations in its Phillips curve. However, from 2014 non-tradables inflation was weaker than the survey and estimates of capacity pressure suggested. Bank research indicated the weakness in non-tradables inflation may have been linked to low past inflation and its impact on pricing behaviour.
This note evaluates whether measures of past inflation could have been used to produce forecasts of inflation that would have been more accurate than using surveys of inflation expectations. It does this by comparing forecasts for annual non-tradables inflation one year ahead. Forecasts are produced using Phillips curves that incorporate measures of past inflation or surveys of inflation expectations, and other information available at the time of each Monetary Policy Statement (MPS). This empirical test aims to determine the approach that captures pricing behaviour best, highlighting which may be best for forecasting going forward.
The results show that forecasts constructed using measures of past inflation have been more accurate than using survey measures of inflation expectations, including the 2-year ahead survey measure previously used by the Bank. In addition, forecasts constructed using measures of past inflation would have been significantly more accurate than the Bank’s MPS forecasts since 2009, and only slightly worse than these forecasts before the global financial crisis (GFC). The consistency of forecasts using past-inflation measures reduces the concern that this approach is only accurate when inflation is low, and suggests it may be a reasonable approach to forecasting non-tradables inflation generally.
From late 2015, the Bank has assumed that past inflation has affected domestic price-setting behaviour more than previously. As a result, monetary policy has needed to be more stimulatory than would otherwise be the case. This price-setting behaviour is assumed to persist, and is consistent with subdued non-tradables inflation and low nominal wage inflation in 2017.