Up FrontWhat are inflation expectations? Why do they matter?Tyler Powell and David WesselMonday, November 30, 2020
Director – The Hutchins Center on Fiscal and Monetary Policy
Senior Fellow – Economic Studies
Why are inflation expectations important?
Inflation expectations are simply the rate at which people—consumers, businesses, investors—expect prices to rise in the future. They matter because actual inflation depends, in part, on what we expect it to be. If everyone expects prices to rise, say, 3 percent over the next year, businesses will want to raise prices by (at least) 3 percent, and workers and their unions will want similar-sized raises. All else equal, if inflation expectations rise by one percentage point, actual inflation will tend to rise by one percentage point as well.
You are watching: If inflation is higher than what was expected
Why does the Federal Reserve care about inflation expectations?
The Fed’s mandate is to achieve maximum sustainable employment and price stability. It defines the latter as an annual inflation rate of 2 percent on average. To help achieve that goal, it strives to “anchor” inflation expectations at roughly 2 percent. If everyone expects the Fed to achieve inflation of 2 percent, then consumers and businesses are less likely to react when inflation climbs temporarily above that level (say, because of an oil price hike) or falls below it temporarily (say, because of a recession). If inflation expectations remain stable in the face of temporary increases or decreases in inflation, it will be easier for the Fed to meet its targets. However, because the Fed has fallen short of its 2 percent objective for some time, some Fed officials worry that inflation expectations may be straying from target.
Here’s how then-Fed Chair Ben Bernanke explained the importance of anchoring inflation expectations in a 2007 speech: “
Central bankers’ focus on inflation expectations reflects the emphasis that academic economists, beginning in the late 1960s (including Nobel laureates Edmund Phelps and Milton Friedman), put on inflation expectations as key to the relationship that ties inflation to unemployment. As a result of the persistently high inflation in the 1970s and 1980s, inflation expectations became unanchored and rose with actual inflation—a phenomenon known at the time as a wage-price spiral. This cycle plays out as follows: high inflation drives up inflation expectations, causing workers to demand wage increases to make up for the expected loss of purchasing power. When workers win wage increases, businesses raise their prices to accommodate the increase in wage costs, driving up inflation. The wage-price spiral means that when inflation expectations rise it is difficult to bring down inflation, even if unemployment is high.
How are inflation expectations measured?
There are three primary ways to track inflation expectations: surveys of consumers and businesses, economists’ forecasts, and inflation-related financial instruments.
The University of Michigan’s Survey Research Center, for instance, asks a sample of households how much they expect prices to change over the next year, and five to ten years into the future. The Federal Reserve Bank of New York and the Conference Board field similar surveys.
The University of Michigan’s survey of consumers finds inflation expectations in recent years hovering at about 2½ percent—well above today’s actual inflation rate, and also higher than inflation expectations derived from markets or economic forecasters. This seems to suggest that consumers expect inflation to rise above its current trend over the next ten years. However, consumers also perceive actual inflation to be higher than its official readings. For this reason, analysts focus on the trend in these surveys—whether consumers expect the pace of inflation to be rising, falling, or remaining stable—rather than the level of expected inflation.
The Survey of Professional Forecasters (SPF) surveys professional economic forecasters on their outlook for two major government measures of inflation, the consumer price index (CPI) and the personal consumption expenditures (PCE) price index (which is the Federal Reserve’s preferred measure).
One widely used gauge of market-based inflation expectations is known as the 10-year breakeven inflation rate. The breakeven rate is calculated by comparing 10-year nominal Treasury yields with yields on 10-year Treasury Inflation Protection Securities (TIPS), whose yield is tied to changes in the CPI. The difference between the two approximates the market’s inflation expectations because it shows the inflation rate at which investors would earn the same real return on the two types of securities. If investors expect higher inflation, they will buy 10-year TIPS instead of nominal Treasuries, driving down yields on TIPS and driving up the breakeven rate. A similar measure, also derived from Treasury spreads, is the 5-Year, 5-Year Forward Inflation Expectation Rate. This is an estimate of inflation expectations for the five year period that begins five years from the present. Like the breakeven rate, it is calculated by comparing TIPS yields with nominal Treasury yields. These market-based indicators are, however, imperfect measures of inflation expectations, as they combine true expectations for inflation with a risk premium—compensation that investors require to hold securities with value that is susceptible to the uncertainty of future inflation.
Federal Reserve economists recently created the Index of Common Inflation Expectations (CIE), which combines 21 indicators of inflation expectations, including readings from consumer surveys, markets, and economists’ forecasts. In a speech hosted by the Hutchins Center, Federal Reserve Vice Chair Richard Clarida said that he will be watching the CIE as he evaluates whether the Fed is achieving its price stability goal. As the chart shows, inflation expectations by this measure seem quite stable and close to the Fed’s 2 percent target.
How can the Fed influence inflation expectations?
The easiest way is to use its monetary policy tools to achieve and maintain inflation around 2 percent. However, the Fed can also influence expectations with its words, particularly by elaborating on how it intends to use its monetary policy tools in the future to achieve the 2 percent goal.
To this end, in August 2020, the Fed modified its monetary policy framework. It is sticking with its 2 percent inflation target but now says that it intends to offset periods of below-2 percent inflation with periods of above-2 percent inflation, an approach it is calling Average Inflation Targeting (AIT). In its old framework, if inflation fell below the 2 percent target, the Fed pledged to try to get it back to target without compensating for the period of inflation shortfall. The change makes explicit that, following a period in which inflation has fallen short of target for a time, the Fed will accept and even encourage periods of above-2 percent inflation going forward, discouraging a decline in inflation expectations.
Why does the Fed worry about inflation expectations falling too low?
When inflation expectations are anchored at target, it is easier for the Fed to steer inflation to 2 percent. If inflation expectations move down from 2 percent, inflation could fall as well—a reverse wage-price spiral. In the extreme, this process can increase the risk of deflation, a damaging economic condition in which prices fall over time rather than rise.
Another reason that the Fed worries about low inflation expectations is that they are closely related to interest rates. When setting prices on loans, lenders and investors account for the expected rate of inflation over the life of the loan. Nominal interest rates are the sum of the real interest rate that will be earned by lenders and the expected rate of inflation. When nominal interest rates are very low, as they are now and are projected to be in the near future, the Fed has less room to cut interest rates to fight a recession. By keeping inflation expectations from dipping too low, the Fed protects its ability to stimulate the economy during downturns.
Fed Chair Jerome Powell discussed this while announcing the new framework: “Inflation that runs below its desired level can lead to an unwelcome fall in longer-term inflation expectations, which, in turn, can pull actual inflation even lower, resulting in an adverse cycle of ever-lower inflation and inflation expectation. This dynamic is a problem because expected inflation feeds directly into the general level of interest rates. Well-anchored inflation expectations are critical for giving the Fed the latitude to support employment when necessary without destabilizing inflation. But if inflation expectations fall below our 2 percent objective, interest rates would decline in tandem. In turn, we would have less scope to cut interest rates to boost employment during an economic downturn, further diminishing our capacity to stabilize the economy through cutting interest rates. We have seen this adverse dynamic play out in other major economies around the world and have learned that once it sets in, it can be very difficult to overcome. We want to do what we can to prevent such a dynamic from happening here.”