Here's how badly central banks failed to spot inflation shock

Global central banks made one of their biggest forecasting failures on record when they woefully underestimated the magnitude and duration of the worst inflation surge in decades.

As the following series of charts from the Group of Seven economies shows, most central banks have made repeated errors -- forcing them to continuously revise up their forecasts for consumer prices. 

And the lack of predictive power is having repercussions.

The Federal Reserve and most counterparts are now racing to make up for lost time by raising interest rates the most in decades. That means borrowing costs may end up higher than if the hiking started sooner. And the record of failure on forecasting could undermine confidence in the current assurances that a soft landing is still possible.

Indeed, the fallout going forward includes a greater risk of recessions as officials seek to regain control of inflation. Politicians could end up seeking greater oversight of monetary-policy matters -- all the more so in the Fed's case if Republicans win control of one or both of the chambers of Congress in November's midterm elections.

"In 2021, our central bank let us down quite badly," said former Treasury Secretary Lawrence Summers, a paid contributor to Bloomberg Television. It's had a "poor forecasting record -- and I have to say that it's not something that's been fully fixed."

The median prediction of Fed officials in June showed inflation coming back toward the 2% target but unemployment only reaching a high of 4.1% by 2024. That's a "highly implausible" result, said Summers.

Fed Chair Jerome Powell and his peers concede errors were made. They reckoned inflation would prove "transitory" because they assumed pandemic-related strains such as stressed supply chains and outsized demand for goods would fade as the coronavirus ebbed and lockdowns ended.

"Really the learning, I think, is around how complicated the supply-side issues can be," Powell said Wednesday in discussing the Fed's bad call on inflation in 2021.

Some also hoped that waiting on the shift toward tightening would improve the health of labor markets. 

Instead, as central banks kept ultra-loose policies, people kept spending and commerce remained fraught. The war in Ukraine and China's Covid Zero program, which lie outside the influence of monetary policy, compounded those forces to propel the cost of food and fuel. Tight labor markets also ignited wages., and massive fiscal stimulus in some economies fanned demand too. 

Bloomberg Economics now says global inflation won't peak until 9.3% in the third quarter. 

To be sure, central bankers weren't alone in failing to fully grasp the scale of the inflation problem. Back in February, the US five-year, five-year forward breakeven rate -- one of the Fed's preferred measures for market expectations around inflation over the next decade -- was pricing in average annual price gains of just over 2%, close to the central bank's target level. 

Likewise, the median estimate of economists surveyed by Bloomberg around the end of 2021 was that US headline consumer-price inflation -- then running at 7% -- would be around 4.3% for all of 2022. Instead, price gains have already exceeded that in just six months and analysts have raised their forecasts. 

Politicians, from whom central banks have enjoyed measures of increased independence over the decades, are taking note. The Australian government has launched a review of its central bank's forecasting, while UK Foreign Secretary Liz Truss has suggested she may change the Bank of England's mandate if she becomes prime minister in September.

In the US, Democratic Senator Jon Ossoff said Thursday the Fed's 2021 policy actions are "now water under the bridge." Republicans may not be so forgiving if they're in charge of Capitol Hill next year.

"Central bankers need to reflect deeply on the management of monetary policy over the past two years and review their models and the assumptions and judgments they made," former New Zealand central bank governor Graeme Wheeler wrote in a co-authored report published this week. "The main cause of inflationary pressures lies in the errors of judgment made by central banks in conducting monetary policy during the Covid pandemic."

— With assistance by Benjamin Purvis, Erik Hertzberg, Vince Golle, Zoe Schneeweiss, Andrew Atkinson, Paul Jackson, and Tracy Withers

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.