Inflation forecasts and market expectations.

How high will inflation go? When will cash rates peak? What can we expect from growth in the future?

We don’t have answers to these questions, but they do tell us something about the relationship between inflation forecasts and market inflation expectations.

Inflation forecasts are the numbers economists produce for where they expect inflation to be in the near term, usually over the next year or two. These forecasts are prepared by the private sector and official economists, the latter often working at a country’s central bank, given the importance of inflation as an input to monetary policy.

Market expectations, on the other hand, are entirely different. These are inflation expectations over very long periods derived from bond market pricing.

Because bond yields represent a return to the investor intended to compensate for inflation over the life of the bond, then we can say something about expected inflation. For long-term bonds, this average expectation for inflation might be for the next 10, 20, or even 30 years.

When we combine economist inflation forecasts and market expectations for inflation, we have two very different views of the future. Each is important in its own way for setting monetary policy.

Stocks and bonds are both reflections of expectations and forecasts. These inputs also shape the market’s view on expected returns. Higher inflation will require higher returns to compensate. This, in turn, necessitates lower asset prices and higher earnings.

The apparent disadvantage of inflation forecasts and market expectations is that they are just that: forecasts and expectations. They are not guaranteed to be correct, and because predicting future events is impossible, they are always wrong to some extent

On the forecasting side, we know that forecasting economic variables for as little as one year into the future has a mixed track record at best. Once we move further out, to say two years, forecast errors become significant. Market practitioners fare little better in inflation expectations or other market pricing. Large corrections to financial market prices are a seemingly permanent feature of markets and bear testament to that.

The difficulty is so well known that researchers have established that current market prices or variables outperform more sophisticated models as an estimate.

If forecasts and expectations can never be entirely correct, how should we invest in inflationary environments? History has shown that over the long term, a balanced portfolio of equities and shares, designed to meet your risk tolerance, has outperformed inflation.

The role of inflation forecasts and market expectations continue to pose challenges for policymakers, but as an investor, prudent portfolio construction designed to deliver long-term returns through a range of scenarios is something you can invest in with certainty.

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