Backtesting central bank forecast data shows the need for Inflation Forecast Markets.
Inflation has been unstable over the past 2 years. But is this just an anomaly, or are central banks consistently being inaccurate?
To answer this question, we backtested the Fed's and Bank of England's inflation forecast data and compared their predictions with reality.
Comparing US and UK inflation and their central banks' respective 1-year forecasts, one pattern emerges: central banks consistently underestimate the volatility in inflation that arises due to economic and financial crises such as the 2008 crisis and the 2020 Covid-19 crisis.
US Inflation (blue) overlayed with the Federal Reserve's 1-year forecast (orange)
UK Inflation (blue) overlayed with Bank of England's 1-year forecast (orange)
Analysis of the distribution of the Forecast Error (calculated as CPI outcome – CB forecast) shows that central banks have a poor historical accuracy of forecasting inflation. In fact, 30% of all forecast by the Fed were more than 1% wrong – a margin of error that is unacceptable, given that inflation management is the primary goal of these central banks.
US Inflation Forecast Error Histogram & KDE Plot
UK Inflation Forecast Error Histogram & KDE Plot
Finally, looking at the magnitude of forecasting errors reveals a grim picture. Over the past decades, the Fed and Bank of England became worse at forecasting inflation over time. US data below reveals a jump in inaccuracy following the 2008 financial crisis and the 2021 supply chain disruptions and stimulus spending that emerged from Covid-19.
US Inflation Forecast Error Squared (20-year Moving Average)
UK Inflation Forecast Error Squared (10-year Moving Average)
Few people reflect on how accurate forecasts turn out to be. At Fortunity's core, we learned to never take predictions for granted. By holding central banks accountable, our analysis shows the flaws in our current system of forecasting the economy.
Ultimately, this is an opportunity. By familiarising yourself with trading Inflation Forecast Derivatives, you can get prepare to profit from this inefficiency.
- UK data uses a 'combined inflation' measure due to the Bank of England changing the inflation measure it forecasts at the end of 2003.
- US data was available at monthly frequency whereas UK data was annual. US data was also available for earlier years whereas UK data was not. Conclusions still hold for both countries.