The market is "not believing" in high inflation? JP Morgan: It's been 5 years, and we're still being deceived!

JP Morgan issued a heavy warning, stating that five consecutive years of inflation forecast errors show that developed market central banks and investors have seriously underestimated the persistence of inflation. This ongoing forecasting failure and inflation overshoot may ultimately shake market confidence and raise long-term inflation expectations.

On September 10th, according to news from the Wind Trading Desk, JP Morgan's Global Economic Research Department pointed out in its latest report that the core inflation rate in developed markets is expected to reach 3% by 2025, which means inflation will significantly exceed the central bank's target of 2% for the fifth consecutive year.

Despite central banks predicting each year that inflation will fall back in the following year, reality has repeatedly proven these expectations to be overly optimistic. The Federal Reserve has been particularly notable, having cumulatively raised its one-year forward core inflation forecast by 10 percentage points since 2021.

JP Morgan stated that despite significant inflation overshoots and repeated forecasting errors for five consecutive years, the market still gives central banks high marks for controlling inflation back to target. Moreover, the bank specifically emphasized the risk of the "five-year curse." Historical experience shows that persistent inflation deviations may begin to affect long-term expectations after five years.

It is noteworthy that core inflation exceeding expectations for five consecutive years means that interest rates may remain high for a longer period, central bank independence is under threat, and the risk of inflation expectations becoming "unanchored" is rising. JP Morgan gives a 45% probability of sticky inflation and only a 40% probability of an economic recession.

Central Bank Forecasts "Total Failure": Five Years of Consecutive Errors

Data from JP Morgan shows that developed market central banks have performed "poorly" in their inflation forecasts during this economic expansion. On average, central banks have underestimated core inflation by about 1 percentage point over the past five years, with actual inflation levels exceeding targets by 1.5 percentage points.

Among them, the Bank of England performed the worst, with an average forecast error of 1.8 percentage points, and actual inflation exceeding targets by an average of 3 percentage points. As the core of the global economy, the Federal Reserve's average forecast error is 1.3 percentage points, with inflation overshooting by about 2 percentage points.

Even more concerning is that this pattern of forecasting errors seems likely to continue into 2025. According to current tracking data and JP Morgan's forecasts, the core inflation of the Federal Reserve, the Bank of England, the Swedish Riksbank, and the Norwegian central bank once again faces the risk of exceeding initial expectations.

Among them, the challenges faced by the Federal Reserve are particularly severe, as core inflation (PCE and CPI) is expected to be a full 1 percentage point higher than initial expectations due to tariff impacts.

Market "Selective Blindness": Long-term Expectations Remain Unchanged

Despite facing five consecutive years of inflation overshooting and central bank forecasting errors, financial markets still give a "high score" to the central banks' ability to regain control over inflation.

Based on the market's 5-year, 5-year forward inflation swaps, long-term inflation expectations have only risen moderately since before the pandemic, primarily as a correction to the low inflation environment of the previous decade.

For the United States, Eurozone, and the United Kingdom, 5-year, 5-year forward inflation swaps fell by 50-125 basis points after the global financial crisis. As of August, these indicators have fully recovered and returned to pre-crisis levels.

JP Morgan believes that at least from this indicator, the central banks' credibility in combating deflation remains "exceptionally strong."

The bank notes that over the past three years, long-term market expectations in the U.S. and Eurozone have remained stable, while the corresponding expectations in the UK have declined by about 40 basis points. This stability provides valuable policy space for central banks but may also mask potential risks.

The Approach of the "Five-Year Curse": Historical Lessons Should Not Be Ignored

JP Morgan pays special attention to the phenomenon of the "five-year curse," which suggests that persistent inflation deviations may begin to affect long-term expectations after five years. Data from U.S. household surveys have shown warning signs, with the 5-year inflation expectations in the University of Michigan consumer survey recently jumping, which may indicate that inflation expectations are becoming less stable.

The bank believes that the U.S. experience after the global financial crisis provides important reference. During the post-crisis expansion, U.S. core inflation fell significantly and remained low for an extended period.

During the post-crisis expansion, the 1-year, 1-year forward inflation swaps plummeted at the end of 2009 and remained low throughout the expansion period. Long-term expectations eventually began to decline about five years later, dropping nearly 100 basis points during the 2014-2015 period.

While long-term inflation expectations remained anchored, recent inflation expectations (measured by 1-year, 1-year forward inflation swaps) have sharply declined. The bank refers to this recent forward inflation expectation as a "prominent" indicator, suggesting that if it remains at abnormally high or low levels, it may begin to permeate long-term expectations.

The current difference is that, despite the inflation target being significantly overshot for five consecutive years, the 1-year, 1-year forward inflation swaps have remained well-anchored, except for jumps in 2021 and 2022. Therefore, whether this "prominent" dynamic will play out similarly to the post-crisis expansion period, but in the opposite direction, remains unclear.

Challenges to Policy Independence: Inflation Risks Compounding

JP Morgan warns that when the independence of monetary policy-making is threatened by political influences, the task of re-anchoring expectations becomes more difficult The report specifically mentioned President Trump's recent attempts to fire Federal Reserve Governor Cook and his threats to replace Chairman Powell. Bank of Canada Governor Macklem recently pointed out:

"In a more uncertain world, public confidence in central banks and the value of our ability to provide price stability is more important than ever."

Looking ahead, JPMorgan Chase maintains a 40% probability of a U.S. economic recession, with major risks stemming from trade and immigration policies dragging down demand. However, in the baseline scenario, the risks posed by inflation are also significant.

The bank believes that in the absence of a recession, the risks lean towards another year of sticky high inflation, particularly for the United States.

JPMorgan Chase's scenario analysis shows that the probability of sticky inflation is as high as 45%. In this context, expectations may shift upward, effectively replacing temporary supply shocks with more persistent trade condition deterioration.

Although this situation has not yet occurred, long-term inflation expectations remain well anchored. However, after five years of significant overshooting, households and businesses may eventually begin to question the credibility of the central bank's commitment to price stability and start embedding higher inflation expectations into nominal contracts—including wage contracts.

Once wages and prices begin to rise in sync, the task of re-anchoring expectations becomes more difficult—this is a costly lesson learned from the 1970s. JPMorgan Chase states that this means preparing for an environment of "higher for longer" interest rates, rather than the rapid easing cycle currently expected by the market