Simple Inflation Forecasting Model for

the U.K.
This inflation forecasting model makes use of the quantity theory of money and the equation
of exchange framework.

The equation of exchange variant used is:

M H V H , C =PCPIH C H

Where:

M H is household currency and deposits.

V H ,C is household consumption-velocity of money.

PCPIH is the U.K.’s consumer price index inclusive of housing costs.

C H is household real final consumption expenditures.

The equation in percentage changes (where ∆ is % change) is given by:

( 1+ ∆ M H )( 1+ ∆ V H , C )=( 1+ ∆ P CPIH ) ( 1+∆ C H )

Solving for PCPIH gives us:

( 1+ ∆ M H ) ( 1+∆ V H ,C )
∆ PCPIH = −1
( 1+ ∆ C H )
What keeps this from being a mere truism is the substitution of well-founded assumptions
concerning the value of changes in velocity and real household consumption. This is
represented by:

¿ ( 1+∆ M H )( 1+ ∆ V H , C )
∆ PCPIH = −1
( 1+ ∆ C H )
Where:
¿
∆ PCPIH is our 1st trial inflation forecast.
∆ V H ,C is our assumed trend velocity.

∆ C H is our assumed trend growth in household real consumption.

This leaves open the issue of a) how to derive our trends, b) what is the optimal lag structure
between inflation and the other variables, and c) how to derive assumed values for use in
actual forecasting, rather than just explaining past inflation.
As mentioned, our trends must be based on “well-founded assumptions”. Presumably this
means that the empirics support the values used. Let us begin by observing the behaviour of
household consumption-velocity in the long-term.

Long-term U.K. Household Consumption-Velocity

1985 - 2019
1.3

f(x) = − 0.0148615997910318 x + 30.7794606128227

1.2 R² = 0.893864761031263

1.1

0.9

0.8

0.7
1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015 2018

Data from 1985 to 2019 show that U.K. household consumption velocity has tended to vary
only slightly around a stable downward trend of about -1.5% a year. This feature of
stationarity, or mean-reversion, is also illustrated by the series in terms of annual percentage
changes:

Annual and Trend % Change in Household Consumption-

Velocity
8%

6%

4%

2%

0%

-2%

-4%

-6%

-8%

-10%
89 91 93 95 97 99 01 03 05 07 09 11 13 15 17 19
19 19 19 19 19 19 20 20 20 20 20 20 20 20 20 20

Annual Change in Consumption-Velocity Trend

What about growth in household real consumption? The figure below illustrates:

Annual and Trend % Change in Household Real

Consumption
8%
7%
6%
5%
4% 2.18%
3%
2%
1%
0%
-1%
-2%
-3%
-4%
89 91 93 95 97 99 01 03 05 07 09 11 13 15 17 19
19 19 19 19 19 19 20 20 20 20 20 20 20 20 20 20

Annual Growth in Household Real Consumption Trend

There is evidently much more variability around the trend as compared to consumption-
velocity. As a consequence, we smooth the data by taking leading five-year compound annual
growth rates, giving us:

Smoothed % Change in Household Real Consumption

8%
7%
6%
5%
4%
3%
2%
1%

0%
-1%

-2%
-3%

-4%
89 91 93 95 97 99 01 03 05 07 09 11 13 15 17 19
19 19 19 19 19 19 20 20 20 20 20 20 20 20 20 20

Hence, our assumptions are as follows:

Variable Assumption Value

Annual Trend over 1989 -
∆ V H ,C
2019 Period  -1.49%
Leading 5-Year To be
∆ CH Compound Annual calculated for
Growth each year

Our first trial forecast is as follows:

 First Trial
9%

8%

7%

6%
Actual Inflation

5%

4%
f(x) = 0.400741544308623 x + 0.0171243718671214
R² = 0.20394338616305
3%

2%

1%

0%
-2% -1% 0% 1% 2% 3% 4% 5% 6% 7% 8%

Implied Inflation

Using the equation of the line as a base for our second trial, we substitute our implied inflation
with the x to give us our second trial:
 Second Trial
9%

8%

7%

6%

5%

f(x) = x
4% R² = 0.20394338616305

3%

2%

1%

0%
1% 2% 3% 4% 5%

We calculated the differences between our 2nd trial forecast and actual inflation. We converted
that set into absolute values and derived their mean to get us our mean absolute deviation of
2nd trial forecast from actual inflation. We used this to construct series for the upper and
lower-bound inflation predictions, by adding to and subtracting from our 2 nd trial forecast the
mean absolute deviation, respectively. Hence, we get:
 Boundary Predictions
10%

9%

8%

7%

6%

5%

4%

3%

2%

1%

0%

-1%

-2%

-3%
89 91 93 95 97 99 01 03 05 07 09 11 13 15 17 19
19 19 19 19 19 19 20 20 20 20 20 20 20 20 20 20

Upper Boundary Lower Boundary Actual Inflation

The above was intended to illustrate the basic method by which the model is constructed and
used. It features no lag structure i.e. it is a form of now-casting. We then tested the model
with lag structures ranging from 1 to 3 years. The best results we found were for the 1-year
lag.

The figures below present a 1-year lagged model, using a given year’s data on growth in
household money, smoothed real consumption, and trend consumption-velocity to predict the
range within which next year’s inflation will fall. The latest prediction is for 2022, where CPIH
is predicted to reach between 1.93% and 5.22%.
 First Trial
9%

8%

7%

6%
Actual Inflation

5%
f(x) = 0.306086312921673 x + 0.0166300495055924
R² = 0.268215917380531
4%

3%

2%

1%

0%
-2% 0% 2% 4% 6% 8% 10% 12% 14%

Implied Inflation

Second Trial
9%

8%

7%

6%

5%
f(x) = 0.999999999999999 x
R² = 0.268215917380531
4%

3%

2%

1%

0%
1% 2% 3% 4% 5% 6%
 Boundary Predictions
9%

8%
2022; 5.22%
7%

6%

5%

4%

3%

2%

1%

0%

-1% 2022; 1.93%

Upper Boundary Lower Boundary Actual Inflation