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K-State research shows consumers can predict inflation as well as professional economists

August 26, 2008

MANHATTAN, KAN. -- When it comes to predicting the rate of inflation, professional economists might tell consumers, "Your guess is as good as mine."

Research by a Kansas State University professor shows that household surveys predict the inflation rate fairly accurately and as well as professional economists. The pros employ statistics like the unemployment rate, money supply growth and exchange rate changes. Consumers participating in surveys are more likely to think about how much they spent at the grocery store that week.

"Surprisingly, the median household is just as good as the average professional economist," said Lloyd B. Thomas, head of the department of economics at K-State, where he has been a faculty member since 1968. "I'm a little surprised because economists are using sophisticated models. But the consumers know what's happening with milk prices."

Thomas and Alan P. Grant of Baker University in Baldwin City published a study in the June issue of The Economic Record. They looked at the accuracy of an inflation survey of U.S. consumers versus a survey of Australians. Thomas said the U.S. survey was slightly more accurate, but that could be because the U.S. survey -- which the University of Michigan conducts each month by telephone with 500 households -- more accurately probed consumers' hunches about inflation.

Both surveys, however, showed that consumers have a good idea about where inflation is headed. On average, they're off by 1.3 percentage points. And although they don't get it exactly right, Thomas said they weren't biased. That is, consumers don't consistently underestimate or overestimate inflation.

"It means economists need to improve their forecasting -- or at least be a little humble," Thomas said.

Inflation forecasts matter because they influence many areas of the economy, from wage negotiations and the interest rate, to how businesses set their prices. High inflation can mean businesses spend less on research and development, fewer investors are willing to consider government bonds, and people behave inefficiently, Thomas said. As examples, he said unions spend time and money renegotiating more frequently, and governments and businesses are forced to issue short-term bonds as buyers shy away from long-term bonds.

On a personal level, Thomas said inflation expectations can determine whether people buy houses or how they manage their nest egg.

"Inflation expectations are one of the most important factors in the economic environment," Thomas said.

He said persistent inflation didn't take hold in the United States until after World War II. Before that, a loaf of bread cost about the same in 1940 as it did in 1776. Commitment of government to prosperity and Federal Reserve activism have meant that the price level in the U.S. increased in 59 of the past 60 years. In the 1970s, inflation increased on average 8 percent per year, Thomas said.

In the past year, Thomas said rising food and gas prices have pushed inflation above 5 percent. He said the Federal Reserve would normally need to raise interest rates to slow down spending and inflation. But chairman Ben Bernake and others on the Federal Reserve Board are fearful of a recession.

"Consumers make up 70 percent of total spending," Thomas said. "So if consumers lose confidence, that could bring us into a bad economic situation."

As long-term inflation hedges, Thomas said it is wise to consider investments in the stock market and real estate.

"When there's rising inflation, it's beneficial to be in debt to purchase real assets, because you'll pay your debt back with money that won't be worth as much in the future," Thomas said.

Whereas high inflation helps those who hold real estate and other real assets, it hurts people with bonds. This often includes people with retirement accounts.

"With high inflation, you want to avoid bonds like the plague," Thomas said.

Kansas State University