New, market based prediction methods are proving to be more accurate at forecasting economic data than legacy methods of prediction. In surveys, economists got inflation rates right only 2/10 times, but prediction markets got it right 6/7 times! Inflation rates have been high over the past year and are expected to remain so, which means precision in inflation forecasting becomes much more crucial than in the past. Higher inflation means higher variability in inflation numbers, and every slight change in inflation rates has domino effects that reverberate throughout the economy. Prediction markets create a foundation for using the wisdom of crowds to track the expected level of inflation in real-time.

Methods for Forecasting
Forecasting inflation is an age-old problem and one we haven’t been very good at… People have tried many different methods in their pursuit of precise forecasts - economist surveys are the most popular method, and Bloomberg’s is often considered the gold standard. Other methods use aggregated, crowd-sourced forecasts to create estimates of various inflation rates. The common thing between all these methods: the people making the forecasts don’t have any skin in the game. When an economic pundit is right, they tweet about it on social media. When they’re wrong, well… they just don’t talk about it. All upside, no downside.

A better alternative: markets. Kalshi’s inflation markets have been consistently proved to be more precise in forecasting rates than the other methods. Let's use the gold standard, Bloomberg’s Economists’ forecast, as an example. These economists predicted on average that inflation would be only 0.4% in January, well below real inflation numbers. They underestimated inflation in 8 of the 10 months leading up to February! They were accurate 20% of the time… By contrast, Kalshi’s markets correctly predicted inflation in January and correctly predicted inflation numbers in 6 of the 7 months preceding February, so it was accurate ~85%  of the time.

In this article, we discuss why leveraging the wisdom of crowds is an important complement to forecasts made by economists.

Predicting Inflation is crucial
Predicting inflation is critically important, but also incredibly complex. Inflation expectations are affected by government policy, geopolitical tensions, supply chain shortages, and a myriad of other factors. Currently, a combination of aggressive Federal Reserve policy and commodity shortages resulting from the Russian-Ukraine conflict have created high inflation expectations. Combined with COVID-induced supply chain issues, many believe this has been a recipe for potential hyperinflation.

Younger generations likely won’t understand the real impact of a high inflationary environment - inflation has been low for the last decade and was relatively tame in decades before. History has some stark warnings here, and a key one is that nearly nobody is safe in a high-inflation environment. Understanding the degree of inflation is necessary for businesses seeking to understand how much to charge customers and predict the degree to which input costs will rise. Stock analysts use inflation forecasts to understand companies’ future cash flow projections and the Federal Reserve’s potential interest rate policy response. Even slight miscalculations in inflation projections can have huge, compounding effects. This means accurate inflation predictions are critical for everyone from your local mom-and-pop shop to gigantic, multi-billion dollar hedge funds.

Nearly everybody has been certain inflation will be high for months now. The question is - how high? Kalshi traders answer this question by trading on its exchange, providing real-time estimates on how inflation will trend. These estimates are updated continuously as new information of consequence is released. Currently, markets are estimating a 61% chance of inflation being above 0.9% in March, but only a 28% chance of it being above 1.1%.

How Prediction Markets Work
Kalshi is a form of a “Prediction Market”, a financial exchange in which market participants trade real money on the likelihood of various events happening. Market-based forecasts like Kalshi’s provide an alternative to those provided by pundits. Unlike traditional economic commentators, market participants have real skin in the game directly tied to the accuracy of their predictions. Put simply, pundits are rewarded merely for opining, with little to no consequences for poor forecasts. These pundits have little incentive to be truly accurate. Prediction markets are a new paradigm - their participants’ incentives are aligned with accuracy because they’re rewarded only if they’re right. This means prediction markets update in real-time, allowing their predictions to instantly reflect new economic realities. Below, we can see some examples of where real-time reactions to macroeconomic conditions caused a market to flip inflation expectations towards the right answer.

Psychology experiments have proven time and time again that people are quite bad at prediction when asked questions individually, but extraordinarily accurate when a group of people’s estimates are averaged. Prediction markets also have the benefit of becoming increasingly more accurate over time. Accurate predictors will do better in the market, accumulate more resources, and so have a bigger say in future predictions.

Over the long term, a skin-in-the game based prediction market will provide a valuable tool for fighting against misinformation and holding prognosticators accountable by providing a strong signal to cut through the ever-present noise on the internet. The proof is in the pudding - put a market against a group of economists, and the market wins nearly every time.