RBA unpacks why its forecasts were so wrong

The Reserve Bank of Australia (RBA) has released an assessment of why and how it got its inflation forecasts incorrect in the past year. 

The assessment, a new addition to its most recent Statement on Monetary Policy, comes following widespread censure of its forecasting.  

For example, underlying inflation over the year to the June quarter of 2021 was 1.6 per cent and in the August 2021 statement, the RBA said that inflation was projected to remain at around 1.5 per cent to September 2022. 

However, by September 2022, underlying inflation had risen to 6.1 per cent. 

As inflation rose, the bank had materially upgraded inflation forecasts in each subsequent monetary statement, but the RBA has acknowledged that inflation in Australia over the past year had been “significantly higher than the bank and other forecasters expected a year ago”.

“None of the market economists the bank surveys nor any market-based measures predicted the extent of the pick-up in inflation,” the RBA said in its latest monetary statement.

The RBA suggested that inflation in advanced economies over the past year has exceeded the average of forecasters’ expectations by around 5–8 percentage points. Indeed, it said that the increase in US inflation (which began in mid-2021) was largely expected by market participants to have been temporary, with inflation forecast to return to just above the Federal Reserve’s target by late 2022.  

“While a few economists predicted a rise in inflation in early 2021 owing to pandemic disruptions and strong policy stimulus, the magnitude of the increase was broadly underestimated,” the statement read.

But why?

The central bank goes on to suggest that the prolonged force of inflationary pressures, such as supply chain shocks, had also been expected to be transitory. However, unprecedented events, such as Russia’s invasion of Ukraine, the timing and extent of flooding on Australia’s east coast, domestic energy market pressures and other “disruptive events”, were unpredictable or seemed too unlikely to include in the central forecasts”.

It added that these events have led to large increases in fuel, energy and food prices and have prolonged cost pressures that initially stemmed from supply chain disruptions.

“As one of the largest economic shocks in a century, the inflationary effects of the pandemic-driven imbalance between supply and demand for goods both globally and domestically played an important role in the forecast miss,” the RBA said.

“Other unforecastable shocks — such as the effects of Russia’s invasion of Ukraine and the Australian east coast floods — also contributed,” citing research that has indicated that supply shocks (including Russia’s invasion of Ukraine) were responsible for at least half the increase in inflation in other advanced economies, including Australia.

“These shocks have had a persistent effect on inflation. It is also possible that multiple supply shocks have had a compounding effect on inflation.”

Moreover, the RBA revealed that fuel prices contributed 1.2 percentage points to year-ended headline inflation by the June quarter of 2022 and directly accounted for around 15 per cent of the revisions to headline inflation forecasts by that time.

Other inflationary effects of binding sectoral capacity constraints were also “underappreciated”, the RBA said, such as in the construction sector, where capacity constraints combined with higher materials costs and measurement impacts from the HomeBuilder program led to new dwelling inflation reaching 21 per cent over the year to the September quarter of 2022. 

As such, the stronger-than-expected new dwelling inflation (compared with the model-based forecasts) reportedly accounted for around one-quarter of the miss on headline inflation.

The ongoing consumer demand for goods also exceeded expectations in many advanced economies in the first year of the pandemic and then stayed “surprisingly strong” as restrictions eased,” the statement continued. 

“Even without these production disruptions, supply chains would have struggled to accommodate the sudden and substantial surge in demand for goods seen in many economies,” the RBA continued.

It acknowledged that the forecasts also “underestimated the underlying momentum in the labour market”.

Looking forward, the RBA has suggested that inflation will likely continue to rise, with escalating energy prices expected to directly contribute around ½ percentage point to domestic consumer prices over the year to June 2023, for example.

It concluded that the bank’s suite of econometric models was “not well equipped to capture supply-driven inflation, the signal from global inflation surprises, a change in firms’ pricing behaviour or shocks that are highly uneven across sectors” as they rely “on the statistical relationships that prevailed on average in the past”.

As such, the bank’s inflation models “underestimated inflation over the past year as it is difficult for forecasting frameworks to capture the signal from unprecedented events”.

The RBA therefore concluded: “To address these shortcomings, upward adjustments informed by liaison, surveys and international experience have increasingly been incorporated into the forecasts and more weight has been placed on sectoral models. 

“This reduced forecast errors over the past year compared with a fully model-based approach, but did not eliminate them.”

[Related: RBA governor defends cash rate forecasting]