2013-R102

Modeling the Risk and Uncertainty of Inflation Rate Projections

Risk I Track

R1-2_Presentation_ModelingTheRisk&UncertaintyOfInflationRateProjections_Flynn

R1-2_Paper_ModelingTheRiskAndUncertaintyOfInflationRateProjections_Flynn

Abstract:

“Experience in controversies such as these brings out the impossibility of learning anything from facts till they are examined and interpreted by reason; and teaches that the most reckless and treacherous of all theorists is he who professes to let facts and figures speak for themselves, who keeps in the background the part he has played, perhaps unconsciously, in selecting and grouping them, and in suggesting the argument post hoc ergo propter hoc.”
Alfred Marshall

Correctly modeling the risk and uncertainty of inflation rate projections for Major Defense Acquisition Programs (MDAPs) remains a Holy Grail in defense cost analysis. Seemingly imponderable questions abound, such as what statistical distribution for inflation to use in Monte Carlo simulations, with what parameters, and over what time frame. Simply employing a triangular distribution over the life of the acquisition, with endpoints taken as plus and minus a percentage-point or two from the purported mode, seems wholly inadequate.

This paper focuses on the estimation of probability distributions of inflation rate forecasts. Inferences are drawn from analyses of survey- and market-based measures of inflation expectations. Survey-based measures examine projections of inflation made by government officials and professional forecasters. Market-based measures, on the other hand, focus on expectations inferred from the prices and yields of financial instruments actively traded on Wall Street, by those with “skin in the game,” such as Treasuries and inflation derivatives.

Particularly informative are data from the Federal Reserve’s Survey of Professional Forecasters (1c) and valuations of inflation derivatives (2b), since both yield observations on the variance of inflation expectations, for various time frames, as well as expected values.
(1) Survey-Based Measures
Accuracy of Troika Forecasts. Compares actual versus projected values of the GDP price index.
b. Acquisition Outcomes. Compares cost growth in nominal and real terms, with the delta representing the impact of inflation.
c. The Survey of Professional Forecasters. Administered by the Federal Reserve Bank of Philadelphia, provides direct observations on the second moment, or variance, of inflation projections.
(2) Market-Based Measures
a. The Term Structure of Treasury Yields. The delta between nominal and real yields, after adjusting for risk and liquidity premiums, provides observations on the market’s expectation of inflation.
b. Inflation Derivatives. Swaps in the options market provide data on the expectations of market players hedging against the risk of inflation.

These five distinct but related areas of investigation yield different but complementary measures of coefficients of variation (CVs) for projections of inflation rates. Together, they enable the development of a range of scientifically-sound, historically-based, and market-consistent values to employ in risk and uncertainty analyses. In turn, these will support generating realistic S-curves, executed in then-year dollars, for our life cycle cost estimates (LCCEs).

Author(s):

Brian Flynn
Technomics, Inc.
Technomics Senior Cost Analyst Brian Flynn is based at the firm’s Arlington, Virginia, headquarters where he supports national security efforts and, more specifically, the Naval Center for Cost Analysis.
Dr. Flynn has a deep understanding of and strong working relationships with the Naval Center for Cost Analysis; the Naval Systems Commands; the Office of the Secretary of Defense; Army, Air Force and Marine Corps cost analysis organizations; and major cost-analysis entities within the Ministries of Defense in the North Atlantic Treaty Organization. His areas of expertise include:
Defense planning and capability portfolio analysis
Weapon system acquisition strategy and cost estimating
Econometric modeling
Software cost estimating
Quantitative risk analysis
Earned value management
Defense industrial base analysis
Economic analysis
Corporate financial health analysis.
Before joining the firm in 2012, Dr. Flynn worked in the Naval Center for Cost Analysis as a plank owner and more recently as Special Assistant to the Deputy Assistant Secretary of the Navy(Cost and Economics). He served simultaneously as Study Director and U.S. DoD representative of a NATO/Partnership for Peace task group on independent cost estimating and defense planning.
A recognized analyst and leader in the international defense community, Dr. Flynn received the Department of the Navy’s Distinguished Civilian Service Award, the highest honorary award the Secretary of the Navy can confer on a civilian employee, as well as the Superior Civilian Service Award and the Meritorious Civilian Service Award.
Dr. Flynn has authored or co-authored significant cost-analysis guidelines, studies, and white papers including “A Partial-Adjustment Model for Explaining Changes in Overhead Costs,” “Effects of Competitive Procurement on Weapon System Prices,” and “Weapon Systems Acquisition Reform Act (WSARA) and the Enhanced Scenario-Based Method (eSBM) for Cost Risk Analysis,” all of which were presented at government symposia.
Dr. Flynn holds a Ph.D. in Economics, with distinction, from Georgetown University and M.A. and B.A. degrees in Economics from Virginia Polytechnic Institute and State University.
Most importantly of all, Dr. Flynn has undying pride in his service, over a generation ago, in the United States Marine Corps.

Peter J. Braxton
Technomics, Inc.
Peter J. Braxton is a Senior Cost Analyst and Technical Officer at Technomics, Inc., where he supports the Naval Center for Cost Analysis (NCCA) on data collection and cost research efforts, and Defense Acquisition University (DAU) on curriculum development.
He is a Certified Cost Estimator/Analyst (CCEA) and currently serves as Body of Knowledge Chair for the the International Cost Estimating and Analysis Association (ICEAA). He was named the Society of Cost Estimating and Analysis (SCEA) 2007 Estimator of the Year for contributions in Education. He is the managing editor for development and maintenance of the acclaimed Cost Estimating Body of Knowledge (CEBoK(R)) and its predecessor, Cost Programmed Review Of Fundamentals (CostPROF). He served as SCEA’s Training Chair from 2004 to 2009 and as Training Track chair for nine consecutive SCEA international conferences. He has taught extensively at government, corporate, and society training events throughout the United States, Europe, and Australia.
He holds an AB in Mathematics from Princeton University and an M.S. in Applied Science (Operations Research) from the College of William and Mary. He is lead author or co-author of over two dozen professional papers on cost, risk, and Cost As an Independent Variable (CAIV), including three SCEA Best Paper winners and a Journal of Cost Analysis and Parametrics article.