Why central banks are getting inflation wrong

High above the Bank of England, a weather vane tracking the wind direction connects directly to a dial in the stately building’s Court Room. In the 1800s, the bank’s directors met there, and knowing which way the wind was blowing was crucial.
An easterly breeze meant that ships, loaded with commodities such as copper and wheat, would be sailing up the Thames to offload their cargo, affecting demand for money in the City of London. Westerly winds meant the opposite.
The weather vane is still there, but central banks have largely lost their mastery over the link between commodity markets and monetary policy. With booming raw materials markets driving the fastest inflation in decades, that’s a big problem. As a result, forecasting inflation in 2022 has become more art than science. What’s Vladimir Putin going to do with Europe’s gas supply?
How will Beijing react to record high coal prices? Perhaps that’s beyond the expertise of any central banker. Instead, most of them rely on rather unsophisticated tools to incorporate commodity markets into their
models. Worst is their mechanical use of the futures curve for inflation forecasting.
The futures curve is not a forecast of where commodity prices are heading but rather a snapshot of what the market is willing to pay today for delivery in the future. That’s one of the reasons that the US Federal Reserve, the European Central Bank and others got inflation wrong last year. They assumed, looking at the shape of the price curves, that the worst of the commodity-price increases were behind them. Inflation, therefore, was “transitory.” Wrong.
Central banks themselves are aware of the shortcoming. In 2012, the Bank of England published a paper about its troubles incorporating oil prices into its inflation modeling: “Despite the theoretical link between the futures curve and expected spot prices, the futures curve has not been a very good guide to predicting future spot prices, failing to predict the upwards trend in prices between 2003 and 2008 as well as the collapse and recovery in oil prices since then.”
And yet, in the very same study, the authors argued that the bank should continue using the futures curve for its forecasts. One reason? It’s easier. Today, the Bank of England assumes that, for the first six months of 2022, energy prices will follow the futures curve, and after that stay constant.
In a tight market, as we have today, the shape of the futures curve is particularly misleading as a forecast. Take oil: The curve today is a steep downward slope — something called backwardation. That shape means buyers are willing to pay a premium for scarce barrels for immediate delivery. But the downward slope doesn’t mean that oil prices are due to fall. It’s just an indication of present demand.
For the Brent oil market, the price difference between the contract for delivery in April 2022 and the forward contract for December 2022 is $10 a barrel. A central bank may interpret that as a sign that Brent crude is due to drop from $95 to $85 a barrel from now to the end of the year, a harbinger of weaker inflation.

—Bloomberg