We’re Not Great at Predicting Inflation

“A significant number of properties will be hit with a valuation correction of 20% to 40%, causing many investors to run for the exits, but creating opportunity for other investors to come in and purchase properties at a discount. Even so, we see the number of properties being brought to market down 50% to 60% from a normal year. We expect to complete between $700 million and $800 million in acquisitions this year, compared to a typical year of $1 billion to $1.5 billion.”

- Larry Connor, Founder and Managing Partner at The Connor Group

Hi Nuvo Community,

_{Inflation has been the talk of Wall Street and Main Street alike in recent months and is a crucial metric impacting our economy and policies. It's often believed that inflation expectations, especially official forecasts, can provide a reliable compass for future inflation trends. Our analysis, however, paints a different picture, highlighting the challenges in accurately predicting inflation even just a year into the future. This report delves into the data, methodologies, and intriguing findings that question the reliability of these forecasts.}

_Methodology

_{Data for this analysis was sourced from the Federal Reserve Economic Data (FRED). We utilized time-series analysis to compare Inflation Expectations against actual Consumer Price Index (CPI) figures. The correlations were calculated both with and without a one-year lag in expectations.}

 _{Inflation Expectations and Reality}

_{The initial findings showed a positive correlation of about 0.741 between current inflation expectations and current inflation figures. As you can see in the time series chart below, the two lines move in the same direction quite often, demonstrating a strong positive correlation. The key is this chart does not show how well we predict inflation. It shows how closely our expectations of future inflation correlate to current inflation levels. This means we tend to strongly rely on current inflation levels to “predict” future inflation, commonly referred to as recency bias - The tendency to place too much weight on experiences that have happened most recently.}

_{Prediction vs Reality}

_{To illustrate how well our inflation expectations today line up with actual inflation levels one year from now, we overlaid inflation expectations for one year from now with what inflation ends up being one year from now. The correlation dramatically dropped to approximately 0.233. This significant decrease highlights a disconnect between what was predicted and what transpired, raising questions about the predictive accuracy of these expectations. The chart below illustrates a much weaker correlation between expectations and actual inflation. Notice how the two variables in the chart below rarely move in the same direction.}

_{Year-Over-Year Analysis}

_{To take it a step further, we looked at Year-over-Year changes, which is common practice when analyzing data for correlations. The correlation turned slightly negative. Specifically, non-lagged and lagged data showed correlations of -0.123 and -0.019, respectively. This not only underlines the limitations of inflation forecasts but also suggests that relying heavily on these predictions for future economic planning could be misguided.}

_{Implications For Rate Cuts}

_{While inflation expectations serve as a useful gauge, they must be taken with a grain of salt when applied to underwriting models. We can’t rely too heavily on the expectation that inflation will fall rapidly, leading to subsequent rate cuts. Our takeaway - Don’t assume rates are coming down rapidly, and don’t assume exit cap rates will be much lower than they are today.}

_Conclusion

_{The analysis underscores an essential aspect of economic forecasting: the inherent uncertainty in predicting future trends, especially in the context of inflation. While inflation expectations provide valuable insights, their limited predictive power, particularly when viewed through the lens of Year-over-Year changes, is questionable at best.}

Happy Real Estate!

All the best,

Yuri - Your Real Estate Investigator

Credit: Brian Underdahl, Chief Analytics Officer, Nuvo Capital Partners

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