Introduction to Inflation and Central Banks
Central banks in developed markets have severely underestimated the persistence of inflation for five consecutive years. According to JPMorgan, core inflation is expected to reach 3% by 2025, significantly exceeding the 2% target set by central banks. Despite repeated forecasting errors, the market continues to rate central banks highly on their ability to control inflation.
The "Five-Year Curse"
JPMorgan is particularly concerned about the risk of the "five-year curse," as history shows that persistent deviations in inflation may impact long-term expectations after five years. The bank assigns a 45% probability to the occurrence of sticky inflation and warns that preparations must be made for interest rates to be "higher for longer." The ongoing forecasting error and inflation overshoot may ultimately undermine market confidence and elevate long-term inflation expectations.
Central Bank Forecasting Errors
The inflation forecasts of central banks in developed markets have performed poorly during the current economic expansion. On average, central banks have underestimated core inflation by approximately 1 percentage point over the past five years, with actual inflation levels exceeding targets by 1.5 percentage points. The Bank of England has performed the worst, with an average forecast error of 1.8 percentage points and an average overshoot of actual inflation relative to targets reaching as high as 3 percentage points.
Market "Selective Blindness"
Despite five consecutive years of inflation overshooting and central bank forecasting errors, financial markets still give a high score to the ability of central banks to regain control over inflation. Long-term inflation expectations have only risen moderately since pre-pandemic levels, primarily as a correction to the nearly decade-long low inflation environment. JPMorgan believes that, at least from this indicator, the central bank’s credibility in combating deflation remains exceptionally strong.
Historical Lessons
The U.S. experience after the global financial crisis offers important references. During the post-crisis expansion, U.S. core inflation significantly decreased and remained low for an extended period. However, long-term inflation expectations began to decline roughly five years later, decreasing by nearly 100 basis points during the period of 2014 to 2015. JPMorgan warns that if inflation expectations become "unanchored," it may start to permeate long-term expectations, making it more challenging to re-anchor expectations.
Challenges to Policy Independence
JPMorgan warns that when the independence of monetary policy formulation is threatened by political influence, the task of re-anchoring expectations becomes more difficult. The report specifically mentions President Trump’s recent attempt to dismiss Federal Reserve Governor Cook and his threat to replace Chairman Powell. The Governor of the Bank of Canada, Macklem, recently pointed out that public confidence in central banks and the value of their ability to provide price stability is more important than ever.
Conclusion
In conclusion, JPMorgan’s warning about the persistence of inflation and the risk of the "five-year curse" is a significant concern for central banks and investors. The ongoing forecasting error and inflation overshoot may ultimately undermine market confidence and elevate long-term inflation expectations. It is essential to prepare for a "higher for longer" interest rate environment, rather than the rapid easing cycle currently anticipated by the market. The stability of long-term market expectations provides valuable policy space for central banks, but it may also obscure potential risks. As JPMorgan maintains a 40% probability of a recession in the United States, the primary risks stem from trade and immigration policies that may weigh on demand. However, in the baseline scenario, risks related to inflation are also significant, with a 45% probability of persistent inflation.
