Economists at odds over inflation forecasts for 2012

Will it be 3%, as the market anticipates? Will it run at 3.2%, as "private forecasters" are projecting? Or will it be a mere 2.6%, as the Bank of Israel is predicting?

The range of forecasts for inflation 12 months from now is very wide. Moreover, the rate at which inflation is expected to run in a year's time is of vast importance to investors. The 12-month inflation forecast is the rate based on which government bonds are traded. It is the rate that also therefore determines price (and hence yield ) levels of corporate bonds. Twelve-month inflation forecasts help bond traders decide (rightly or wrongly ) whether a bond is too pricey, on the cheap side, or fully priced.

Why is the range so wide? It isn't because of huge dissension over the state of the economy.

Over at IBI Investment House, for instance, where chief economist Ayelet Nir predicts that 12-month inflation will run at 2.9%, they say they agree with most of the predictions of the Bank of Israel. In its weekly review, IBI added, "We agree that the output gap remains negative, and that it is moderating inflationary pressures. We do not believe that the increase in wages will cause significant inflationary pressures." IBI adds that it is anticipating moderate inflation in the global economy in the year to come.

If there is broad agreement about so many things, why on earth is the range of 12-month inflation forecasts so broad?

Once upon a time, it was all blamed on the tomato. Nobody could have anticipated the extraordinary spikes in price of that red fruit so beloved of Israelis, economists would whimper. Now the culprit du jour is housing prices.

At IBI, they write that they are "less optimistic than the central bank" about housing prices. IBI is expecting home prices to continue to climb, boosting inflation in at least the next few months to come.

Nir isn't the only macroeconomics economist to blame the gap on housing prices. Another chief economist told TheMarker this week that the Central Bureau of Statistics is like a black hole. "The housing index is responsible for a fifth of the consumer price index," he explained. "But nobody - not the economists in the business sector or the state economists or the Bank of Israel - can predict how that index will behave."

The housing index has been behaving inexplicably, he said. "At the start of the year, for instance, it didn't budge. Now it's risen, by a lot." Yet although its weight in the index is enormous and its behavior is downright weird, people are used to blaming the predictably unpredictable behavior of the fresh fruit and vegetables index for variance in inflation forecasts.

This is the thing. The set of economists predicting that 12-month inflation will run at 2.6% are essentially predicting that the housing index won't rise much in those 12 months. The people predicting that inflation will run at 3.2% in 12 months are expecting a further dramatic increase in housing prices.

Don't blame the tomato, dear reader. Its price may spike 40% inside a month, and never mind what eggplants and cucumbers may do - but the strange behavior of the CPI, and the wide gaps in predictions, are due to the housing index.