Sunday, January 30, 2022
Why economic forecasters missed the surge in inflation
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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Looking back can be a useful way to look forward. We learn from our mistakes, or we should do. In a moment or two I shall offer a brief look forward. In the meantime, delayed from its usual appearance around the turn of the year but benefiting from more information, it is time to see how economic forecasters did last year. It provides an opportunity to see for whom the bell tolls, and this time it tolls for the forecasters.

When I last did this exercise just over a year ago, covering how economists did in 2020, bad forecasts were entirely forgivable. Nobody knew at the start of that year that a pandemic was coming, or what the response to it would be. Even if we had done, there would have been a debate about the economic impact. Most of the simulations that had been done, admittedly for flu pandemics, suggested something milder. As it was, the UK experienced its biggest fall in economic activity for 99 years.

Missing that, as I say, was understandable. Only when the pandemic began could economists begin to assess its effects, and many of those assessments were very good. But there was another big error a year later, in January 2021. This time last year forecasters did a poor job predicting the recovery, which should have been much more straightforward.

Those of you who have followed these annual exercises over the years will know that separating the winners from the losers is normally a precise exercise, drilling down to who got closer in percentage points to the outturn. In normal circumstances forecasters do pretty well. The wild swings of the past couple of years have, however, meant a change in my scoring system to something much more broad brush and, even with the help provided by that, forecasters did not cover themselves with glory.

The big story, which I shall come on to, is the failure of economists to predict the surge in inflation. The Bank of England has been criticised for being asleep at the wheel on inflation, by not anticipating its rise. But it was in good company. This time last year most economists thought inflation by now would be close to the official 2 per cent target. Many thought it would be below it. The highest forecast was for an inflation rate of close to 3.5 per cent, compared with the 5.4 per cent we saw at the end of last year.

To explain why forecasters missed the rise in inflation, it is necessary to look into a little more detail at what was expected. Growth last year will have ended up at more than 7 per cent, though it did not feel like it and we do not yet have the final figures.

Most forecasters thought it would be less than that, with an average forecast of 4.5 per cent. But there was a reason for that, and it is only fair to say that they were unlucky. This time last year, the UK was in its third lockdown and there was uncertainty about how rapidly the vaccine programme, then in its infancy, would be rolled out. One particular reason for the low growth forecast was the expectation that the economy would be a hit a lot harder by the third lockdown than it was, thereby dragging down growth for the year. As a result, forecasts for growth in January last year were a lot lower than, say, in the previous September, when the average forecast for growth in 2021 was a very respectable 6.7 per cent.

The other thing forecasters got wrong was unemployment. The consensus was that the end of the furlough scheme would reveal the true condition of the labour market and be followed by a rise in the jobless total. This also fitted the narrative of an economy only slowly getting back on its feet after a third lockdown. But instead of the unemployment rate ending last year at 6.5 per cent, the average forecast, it was only just over 4 per cent. Forecasters did not fully allow for the extent of the shrinkage of the workforce during the pandemic. Higher unemployment might have been expected to bear down on inflation but it did not transpire.

The big rise in energy prices, particularly international gas prices, a significant element of the rise in inflation – energy accounted for about a quarter of inflation at the end of last year – was yet to come.

The unemployment error, in turn, fed through to another error. Would the Bank of England raise interest rates in the context of a big post-furlough increase in unemployment? Most forecasters thought not and, indeed, this was the reason the Bank gave for not raising interest rates in November before, reassured by the labour market data, it did so last month. It is widely expected to do so again this week, its first opportunity to do so since inflation hit 5.4 per cent, though these things are never guaranteed.

Some people did warn of higher inflation on the back of the money supply boost from the huge quantitative easing (QE) undertaken by the Bank and others in response to the pandemic. The most prominent to do so was Tim Congdon of the Institute of International Monetary Research, who said in December 2020: “Our central expectation has to be that the annual increase in consumer prices in one or all of the USA, the Eurozone and the UK exceeds 5 per cent before the end of 2022.”

Interestingly, the highest inflation forecast in the annual comparison from last year was from Economic Perspectives, run by Peter Warburton, a former colleague of Congdon, with a broadly similar monetarist approach. He tops the league table. Patrick Minford’s Liverpool Macro Research group, which also adopts a monetarist approach, though a narrow rather than a broad one – I will not take up space here explaining the difference – was second, though his growth forecast was a lot better than his prediction for inflation. Both have experienced periods near the bottom as well as close to the top of the league table.

What does the record of last year tell us about the outlook for 2022? The average growth forecast for this year is similar to that made for last year in January 2021, 4.5 per cent. There has been a bit of softening of that forecast since the autumn, though not to the same extent as a year ago.

Forecasters think the worst of 2022’s inflation will be in the first half of the year and that, after perhaps reaching 7 per cent, it will end the year at 3.5 per cent, well above the official target. Bank rate is expected to rise to 0.75 per cent, though some think it could go a little further, to 1.25 per cent. Unemployment is predicted to stay around current levels at just above 4 per cent.

Will things turn out exactly lie that? Almost certainly not. But forecasters will be hoping to get a lot closer than they did last year. There is a decent chance that they will.