Keeping track of inflation

In the previous article, I discussed the drivers of the recent spikes in inflation. Do you remember them?

Prices have soared largely because of demand picking up, worsened by supply side uncertainties brought about by COVID-19 and the ongoing Russia-Ukraine war. As an investor, inflation matters because soaring prices may affect your investments in the long run. Today we will talk about how to forecast inflation.

Using historical data to predict the future

There are several ways to forecast inflation. Some use rather complex models that account for the entire economy to project future price values, but these depend on too many assumptions about consumption and government activity.

Some use movements in commodity prices to predict future prices, but these depend on which commodities move strongly with the Consumer Price Index (CPI), which is a weighted average of a representative basket of goods and services. Some use simple statistical models that account for past inflation performance to predict future inflation.

Metrobank’s Research and Business Analytics Department (RBAD) uses past inflation values to forecast future inflation. This method assumes that inflation is steady and past prices can be used to extrapolate future inflation. It is simple. It doesn’t require assumptions about other variables (say, commodity prices) to forecast inflation, and it can capture seasonal changes in demand (e.g., Christmas season, summer, etc.).

The caveat here is that if the recent past is volatile, market conditions will take time before it will be observed as a “past price” in the model, meaning inflation will tend to be understated during rising prices.

To demonstrate, the Philippine Statistics Authority (PSA) has reported 3% inflation for January and February. This means that the model will most likely forecast a lower inflation number for March, since the inflation for the past 2 months has been somehow tame.

Figure 1 shows the forecast plots using the data until February 2022. The forecasts are within the 2-4% range. The projected inflation for March was at 3.1%, with the full year 2022 forecast at 3.4%. The shaded range represents the upper and lower bounds of the inflation forecasts, capturing the uncertainties in projecting future prices.

But this was before Russia started attacking Ukraine. The economic sanctions imposed by the West on Russia in response to its invasion of Ukraine have constrained the supply of oil across the world.

Russia produces about 11% of the world’s total oil, and the expected reduction in oil supply drove crude oil prices to as high as USD 130/barrel. This is on top of the supply crunch brought about by COVID-19 uncertainties and lockdowns in major economies such as China. These events called for an upward bias in the forecasts.

Consequentially, the actual inflation figure for March came in at 4.0%, about 80 basis points higher than the forecast. Figure 2 shows the projected inflation rate. You will see that the mean forecast now hovers around 5-6%.

Looking forward

With the current geopolitical events and supply chain problems, full year 2022 inflation is expected to come in at 5.4%, while 2023 inflation is expected to come at around 3-5%. This wide range for 2023 reflects the uncertainties in the inflation forecast amid the volatility of food and energy prices, with the Bangko Sentral ng Pilipinas (BSP) likely to step in to hike rates and slow down inflation at the expense of economic growth.

In any case, the ongoing uncertainties warrant a closer tracking of inflation figures and continued forecast updates when new inflation numbers come in.

RENZ CALUB is the Deputy Head, Research and Business Analytics Department, of Metrobank.