How Useful Are Leading Indicators of Inflation?

Many economists expect inflation to rise in 1995. These expectations are based on various approaches to forecasting inflation. One approach is based on the standard economic theory that inflation rises when slack is eliminated from the economy and production exceeds capacity constraints. According to this view, measures of economic slack such as unemployment and capacity utilization provide useful information about the inflation outlook. But the relationship between slack and inflation is complicated and subject to variable lags. Uncomfortable with this complex relationship, some analysts rely on alternative approaches to forecasting inflation. One approach is based on “leading indicators” of inflation. The leading indicators typically incorporate information on selected prices to augment or replace information on economic slack. The prices selected are usually key commodity prices that fluctuate more or less continuously in response to changing economic conditions. Prominent leading indicators of inflation include the price of gold, broader indexes of commodity prices, and composite indicators that combine several economic series believed to predict the inflation rate. How useful are these leading indicators for forecasting inflation? This article examines five widely watched leading indicators. The first section evaluates the strengths and weaknesses of these indicators based on economic theory. The second section evaluates the leading indicators empirically, looking at how the indicators have performed by themselves and whether the indicators add useful information to a standard model relating inflation to economic slack. It is concluded that, of the five leading indicators, the composite indicators have given the most useful early warning signals of inflation turning points, but none of the indicators has recently been successful in predicting inflation magnitudes.