Inflation and Inflation Expectations

Article excerpt

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11 .05.09

Inflation expectations play a crucial role in monetary policy making. Not only do they tell policymakers something about the real expected cost of borrowing and hence the viability of investment plans, they also help policymakers gauge the public's perception of the central bank's commitment to maintaining a low and stable rate of inflation. Especially in the current policy environment, where the Fed has been forced by events to take unconventional actions, it is more important than ever to make sure that long-run inflation expectations are well anchored and that the policy message is well understood by the public.

In principle, expectations are not observable. But there are at least two sources that can be used to infer them: surveys and market-based information. With surveys, people are asked directly what they think future price growth will be. There is a variety of surveys that are regularly conducted and that target different types of participants. Here, we will focus on the University of Michigan Surveys of Consumers, the Livingston Survey, and the Survey of Professional Forecasters (SPF). Measures taken from readily available market-based information usually exploit information that is contained in the yield curve of Treasury securities. In particular, some measures rely on the yields of Treasury inflation-protected securities (TIPS), which are traded daily in the secondary market. (See this Commentary for a new method of gauging inflation expectations).

The University of Michigan survey is different from other surveys because participants are actual consumers and not professionals, as they are in the Livingston, the SPF, or the Blue Chip surveys. A look at the survey's measure of one-year inflation expectations (1978-present, monthly frequency), shows that the median forecast quite often lags actual inflation, which suggests that current inflation plays an important role in determining inflation expectations. Most of the time, actual inflation falls inside the 25th and 75the bands, with notable exceptions in the 1980s and most recently: The 2009 dramatic drop in prices was completely unexpected. It is also worth mentioning that the variety of opinions is quite substantial. For example, in the latest available reading of September 2009, only half of the people surveyed reported an inflation forecast that was between 0.1 percent and 4.9 percent; the rest had even more extreme views! In any case, all the percentiles tend to move together and, after increasing the substantially in the spring and summer of 2008, the latest figures give us a description of short-run inflation expectations just below their historic average.

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The five-year forecast also has a very similar pattern, with the latest numbers close to their normal levels. However, this series is much less volatile, and, accordingly, the 25th and 75th percentile bands are also narrower. Given the longer horizon, we might be surprised to see that the recent median inflation expectation is quite stable around 3 percent, which is higher than the actual inflation comfort zone of 2 percent--2.5 percent described often by the Fed. In part, this might reflect a bias due to fact that, when people think of the CPI, they put less emphasis on the prices of goods they buy less often, like durable goods. At the same time, the prices that have decreased the most in the last few decades have been exactly those for durable goods. Moreover, it is also true that the forecasts vary substantially, which may be in part because each individual consumer perceives inflation in terms of his or her own personal consumption bundle. In any case, the graph above shows that the medium-run inflation expectations of the participants in the University of Michigan survey have not changed.

If the two charts above tell us what common people think about inflation, the next two show what professional forecasters and other business professionals think. …