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Wednesday, May 26, 2021

Inflation forecasts — like everything else — have been too conservative

If there's been one consistent theme during the recovery it has been analysts, strategists, economists, and forecasters of all stripes being too conservative in judging the resilience of the U.S. economy.

And inflation data is no exception.

In an email to clients published Tuesday, Deutsche Bank strategist Jim Reid highlighted the following chart which shows that inflation data have been, well, just about off the charts.

Reid notes that unlike during the financial crisis, downside surprises to prices weren't seeing during the pandemic recession while the upside shocks have already exceeded any prior cycle.

This time is different, or so the saying goes.

And in Reid's view, this calls into question the insistency from economists and Federal Reserve officials that inflation pressures will prove to be transitory.

"While it is easy to blame transitory factors, these were surely all known about before the last several data prints and could have been factored into forecasts," Reid writes.

"That they weren’t suggests that the transitory forces are more powerful than economists imagined or that there is more widespread inflation than they previously believed... the fact that we’re seeing an overwhelming positive beat on U.S. inflation surprises in recent times must surely reduce the confidence to some degree of those expecting it to be transitory."

And what really stood out to us in Reid's argument is how it raises an important tension between investors and economists that will likely form the basis of this summer's primary economic debate. And that is the tension between magnitude and duration.

As readers are no doubt familiar, transitory is the hottest word in the world of economics right now. Applied by central bankers and economists to describe inflation that will not be sustained, transitory simply means something that is not permanent. Our time on Earth, for example, is transitory.

But describing inflation as transitory passes judgment only on the duration of the anomaly, not the magnitude of the change. The transitory argument from central bankers simply says that this year's rise in prices will not be sustained next year. This view does not offer guidance on by how much this year's prices may change.

But the market conversation around inflation, as Reid suggests, appears to say these ideas cannot be separated. Speaking at a conference on Tuesday, Morgan Stanley CEO James Gorman said he expects the Fed to raise rates early next year, or 18 months sooner than his firm's economists are currently forecasting.