The Federal Reserve cares about what people think inflation will be in the future, and they are typically monitoring future expected inflation by various measures. A recent report by the Federal Reserve Bank of New York shows that inflation expectations over the next year based on the Survey of Consumer Expectations are on the rise, reaching 2.83%. This one-year measure is higher than they have been in about a year (see 2016 version of same report when they suddenly fell to 2.5% from 2.8%). While expectations based on this survey are up, the all time low measure was 2.5% in 2016, and the current value is down from levels when the survey first began in 2013.
In comparison, one-year inflation expectations, in the Atlanta Fed’s firm-level survey-based measure are remarkably stable just at or below 2%, and the Cleveland Fed’s model of ten-year inflation expectations have recently just risen above 2% per year for the first time in many years.
One other measure of expected inflation compares the difference between returns on 10-year Treasury bonds and 10-year inflation-protected Treasuries (or TIPS). This measure–called the 10-year breakeven rate–has recently risen to 2.12%, the highest level since 2014. It suggests investors expect the U.S. inflation rate to be running at annualized 2.12% on average within a decade, slightly above the Fed’s 2% target.
The Federal Reserve itself offers a consensus forecast based on measures put forth by the individual central banks. Looking at the graph above, you might notice that today’s inflation measures are below 2%, but they expect them to rise to about 2% in the next couple of years.
Recent measures of actual inflation for headline inflation touched above 2% for two months in 2017, the first time this occurred since April 2012. We have tended to now undershoot the Fed’s target for medium term inflation for the better part of six years. There are many measures of inflation, and survey-based measures do give some insight on how these expectations are formed and used.
Fed research from St. Louis, suggests these inflation expectations are not all that accurate. Furthermore, the San Francisco Fed finds that market-based measures do not appear to offer much information about future inflation as one might expect. However, it should be noted that people probably make plans on their investments, and wage setting based on what they expect inflation to be. With that being said, it appears as though the Fed’s inflation expectations play a role in their future policy, as noted by former Fed Chair Ben Bernanke (if you are going to read one thing here, make it the Bernanke article).
Issues you might want to address:
- Why do you think consumer expectations of inflation are so out of line with other measures of inflation expectations? Is there a secret plan by the Fed to manipulate inflation measures? Many people think so, but there might be a simpler reason. One can think of how inflation expectations are very slow moving, and therefore it is difficult to move expected inflation from its level.
- How do you compare market and survey-based measures of expected inflation? Which ones have historically been more accurate if they have been accurate at all? What other information that is available in survey-based measures gives us any insight about how people plan for inflation in the future?
- How do you think the Fed “thinks” about inflation expectations? Note that Janet Yellen and now Jerome Powell have mentioned that they believe inflation will meet it’s medium-term target of 2%, given market and survey based measures of expectations simply do not align with that.
- Please feel free to address any other pertinent questions that are not specifically mentioned here, and feel free to bring in outside sources for help.
25 thoughts on “ECON430-Topic #3: Changes and Inflation Expectations”
Consumer’s inflation expectations are consistently higher than what is actually observed. A FRED graph of expected vs actual inflation measures shows that expected inflation was consistently below actual inflation up until the great inflation of the later 1970’s. Prices were inflated above 14% per year at the peak around 1979, only after Paul Volker stepped in as FOMC chair 1979 did prices begin to deflate. Since then there has been a trend with the public of expecting inflation to be higher than it actually is. It seems that a history of greed and deceit by wealthy American businesses has lead the public to be continuously pessimistic about economic outlook. In our nation’s history, times of high inflation have caused turmoil and has given inflation a bad connotation. The Forbes article, “Ben Bernanke’s Secret Inflation Plan” said that inflation can be healthy for the economy at times, but every economist knows there are winners and losers with every economic decision. Overall, it seems that the general public is uninformed about the real effects of inflation and what causes inflation to rise. Because of this they do not realize short term borrowers can be helped with higher inflation, and that some level of inflation is believed to be helpful for real GDP growth. Knowing the public’s general fear of changes in steady state levels of inflation, the Fed will have to be quiet and deliberate about monetary efforts to control inflation. Inflation measures impact people more depending on their financial situation. Companies whose finances are highly invested, social security recipients, and foreign investors in the US market should be concerned with inflation measures because their finances depend on interest rates, exchange rates, and inflation. Why does the public tend to overestimate inflation expectations? A combination of lessons learned from the past, distrust, and uninformed opinions.
Andrew, I agree that the general public is uneducated when it comes to inflationary issues, and they do not understand that inflation can help borrowers with fixed loans. However, it is no secret that inflation growing at unexpected rates can be bad. For example, if prices for goods continue to rise at unexpected rates, when wage rates are clearly lagged, it will be hard for households to adjust, so I disagree with your stance that consumers should not dislike inflation – Unexpected inflation is what consumers should dislike as it does not allow for us to make reasonable predictions about the future.
Market-based measures of inflation and survey-based measures of inflation are not one in the same. Each prediction relies on a contrasting approach to arrive at an expected inflation rate. Market-based measures take the form of the inflation swap rate (“expectations of inflation in the consumer price index one year ahead”(1)) and the breakeven inflation rate (“the difference between returns on 10-year Treasury bonds and 10-year inflation-protected Treasuries”(2)). Survey-based measures are derived from samples of consumers, forecasters, and economists, who provide useful data about their inflation predictions. Advantages of a market-based approach include the ease at which financial asset prices can be accessed and the reliability of the information used. Advantages of surveys include convenience and the usefulness of real time data of expectations. Despite some obvious advantages, a study from the mid-2000’s showed that both measures over-predict the actual rate of inflation with survey-based being higher than market-based (3). A measurement of the root mean squared error from both forecasts in the same time period yielded the same result (3). In contrast, another study across the same period suggested that the survey method is more accurate (1). It seems that the 2008 recession and the instability of the economy during this time period, had an erratic effect on financial market, consumer, and forecasting behavior. Ultimately, there appears to be two calculations that derive a rate but seldom behavioral explanation. A lack of explanation still remains in more recent times as well. Though it is clear that the expected inflation rate is beneficial to the Fed’s operations, the inconsistent predictions generated from market-based and survey-based measures imply that neither is dominant. Ben Bernanke states that “in conducting such simulations, the analyst must specify how inflation expectations are formed.”(4) As for now, explanations “remain speculative”(4) implying the measures serve limited functionality.
Historically the public’s inflation expectations have been slightly higher than what is actually observed. Experience suggests that high and persistent inflation undermines public confidence in the economy and in the management of economic policy (1). One reason why consumer expectations of inflation might be out of line with the Fed’s inflation goals is that “people do not have full information about the economy or about the objectives of the central bank, but they instead must make statistical inferences about the unknown parameters governing the evolution of the economy” (1). This is why the Fed should not have a secret plan to manipulate inflation measures because the Fed should make their plans for keeping stable inflation open to the public.
This type of secret manipulation could create economic problems in the future and could lead to bad policy decisions in the future as well. An example of inflation manipulation can be seen when countries implement price controls or fix prices. This form of manipulation usually doesn’t work since it causes market participants to exit the market, leading to less supply and ultimately higher prices in the long run. Artificially manipulating inflation measures could have a similar effect in that consumers and business make decisions based on these measures. If they turn out to be lower or higher than actually reported, it could cause them to quickly change purchase decisions.
The fed should be mindful of unanticipated inflation and concerned about the rate of change in inflation, but it should also give people full information about the objectives of the central bank and the policies it is implementing to achieve its inflation targets and not have a secret plan to manipulate inflation measures.
Inflation expectations play an important role in determining actual inflation. Firms, policymakers, households, and other economic agents make decisions based on expected inflation. The Fed’s long-term target for inflation is 2 %. (1) Survey-based measures are less accurate than market-based measures of expected inflation. Survey-based measures provide forecasts of inflations from CPI (consumer price index) and PCE (personal consumption expenditures). (2) This method may provide real-time feedbacks, but it usually overstates inflation expectations with CPI. (2) For example, over the past 10 years, the average inflation expectations from survey-based results are around 3 %, which is higher than the Fed’s target and the average of actual inflation. (2) Consumers form their inflation expectations based on the changes in prices of daily-consumed goods and incomes. (3) However, people may have their own biases when forecasting inflation because each household consume different types of products and earns different incomes. Thus, market-based method provides a less accurate estimate as it relies on opinions. Market-based measures of expectations are more informative and thus, provide a better sense of changes in inflation expectations. Market-based measures are calculated from the prices of financial securities. (4) These securities are well monitored, so they provide better estimates with more accurate data. Expected inflations measured by the market-based method are close to the Fed’s target. For example, the average of inflation expectations from market-based method over the past 10 years are 2.09 %, which is very close to the Fed’s target. (5)
The inflation rate is a tool often used because of its adversity to political influence. However, the basis to which using inflation expectations as a way to change monetary policy relies on trusting a rational public with complete and true information that, in reality, is equally as exposed to politics and uncertainty (1). In a study called “what do the Irish Know about Economics?”, it was found that “only 11% of the general public had knowledge of the inflation rate”(2). A lot of this uncertainty lies in how the public was and is educated about the economy, a mistrust in the government, politics, and publications, and finally, an ignorance to monetary policy and its impacts. Evidently, the general public does not always concern itself with the day-to-day manipulations of the Fed regarding inflation expectations. However, their confidence in the government and economy do play a large role in its overall performance and welfare, making it an important consideration for the Fed and its decision-making. “Measurement is only one aspect of understanding inflation expectations” (3), meaning the act of finding, surveying and weighing the reliability of the measured expectations is only the first step to a process that influences the decisions for an entire economy. Further, in order for inflation expectations to have any effect on monetary policy, people have to actually be acting upon their already unstable expectations. In conclusion, inflation expectations are extremely difficult to estimate and even more difficult to effectively put into action, therefore should not be used to represent the generally uneducated and unaware population.
One reason consumer inflation expectations have not lined up with other measures of inflation expectations is due to ignorance. A good portion of the public do not have a clue what the actual rate of inflation is close to. Rand Paul, a 2016 presidential candidate, even seemed to be unclear on inflation expectations, saying, “They’re [inflation] rising because of big government debt,” at a time where inflation was not only low, but falling (Economist). If a presidential candidate, one with a team of economist, had trouble with his inflation expectations, the average consumer is going to have even more trouble. Some people also do not have a clear grasp of what inflation truly is. Because of the link between inflation and rising price, people tend to consider inflation a problem no matter how high it may be; 60% of the people with no college education considered inflation a bit problem (Pew Research Center). This is also displayed by those who are most hurt by rising prices as 59% of those making less than $30,000 a year considered inflation a big problem (Pew Research Center). Stable prices may seem like a big problem when you need a price drop to afford certain items. However, high consumer inflation expectations may be due to a disconnect between various inflation measures and what people buy and consider important. Many inflation measurements assign different weights to certain items, and it is possible that consumers do the same. For example, David Stockman created a measurement that, “gives more weight to food, energy, housing and medical costs than the Labor Department’s figure,” a measurement that has inflation running at 3% (LA Times). With this inflation lines up with consumer expectations, so the reason for higher expectations could simply be due to the weighting of items.
In economics, the role for future expectations is highly important. Take an increase in prices in the future as an example. When consumers believe prices for a certain good will go up, the consumer will most likely buy the good now instead of waiting to buy it at a higher price. An increase in taxes is another example. If taxes are expected to rise, then consumers will increase their savings to still be able to pay for their mortgages and bills (1). According to an article in World Economic Forum, as soon as expectations are introduced into the economy, fiscal policies are essentially indeterminate. Reason being, the policy will greatly be affected by consumers’ own beliefs and thoughts (1). Bloomberg Markets talks about how the Fed, five years ago, implemented a target rate inflation of 2% (2). Inflation expectations are on the rise, nonetheless, reaching approximately 2.83% (3). This is higher than the last few years. The thing with expectations are, they usually end up being correct because people act according to what they think will happen. This results in the expectation coming true, potentially even in a faster matter. Inflation has increased from 1.6% in 2017 to just over 2% today (5). It would not be a shock if it kept rising in the future due to consumer expectations on inflation.
Both market and survey-based measures of inflation are not completely accurate, with survey measures being worse than the former. Consumer expectations of inflation are usually inaccurate to actual future inflation because inflation is not a daily factor present in most spending decisions. In a paper, written by the Federal Reserve Bank of San Francisco, it states that households are “placing too much weight on recent headline inflation”. This implies that individual consumers are not taking in all information that is available and instead relying on heuristics to make assumptions about future price changes. Grocery stores and gas stations, for example, primarily shape ideas about inflation as people tend to spend money in these places often. The Fed, however, measures inflations through the PCE excluding food and energy because of the added volatility.
The market-based measure through the Treasury Inflation Protected Securities market does a better job of more accurately predicting future inflation, primarily due to a more rational reaction to more information, making the market for TIPS more forward-looking. The downside for this measurement, however, is that it also contains some additional information based on liquidity preferences and changes in risk tolerance by investors. These added variables distort a pure measurement of inflation.
The Fed has been combating with the issue of achieving their target inflation
rate of 2%. Both Fed chairs, Janet Yellen and her successor, Jerome Powell, have found that inflation has drifted below its target and are worried inflation expectations of the coming future will also be below inflation targets (1). Jerome Powell believes that the only way to “anchor” inflation expectations is to actually achieve a 2 percent inflation rate (2). The issue with this plan is that actual inflation has reached 2 percent a numerous amount of times (end of 2007, Jan 2010, and end of 2012) yet inflation has fluctuated above or below the 2 percent target, never staying near-constant with the target. Recently, according to Atlanta Fed research director David Altig, arguments for the Fed anchoring below 2 percent could be made and supported (3). This brings up a problem for the Fed’s plans of achieving any sort of inflation goal: a defense of the Fed’s inflation credibility. Not only is the Fed trying to “anchor” the inflation rate expectation and the inflation itself at 2 percent but they are also trying to protect their credibility with the public about handling inflation. With anything related to a goal being achieved, the credibility of an institution (the Fed in this case) or as Bloomberg columnist Narayana Kocherlakota, a former president of Minneapolis Fed, states the public heavily focuses on “one’s track record” (3). This can possibly explain why the public’s inflation expectations are relatively higher than the target inflation rate of 2 percent and the Fed has had a particularly lower expectation of future inflation rates. The public maybe looking at the “track record” of the Fed and simply go against what they say, with the belief that they never were truly “right” with their expectations and will be the opposite.
I do agree that the Fed looks after its own credibility to effectively gain the public’s trust that they are capable of keeping inflation where they want it. Sometimes I see the relationship between the Fed and the public sometimes be described as a feedback loop where the public trusts the Fed to meet inflation targets, which leads to better long run expectations, which leads to the Fed hitting fixed goals of inflation, and the cycle continues. All of this assumes that the public has a general consensus of what the Fed’s goals are and can rationally expect the Fed to hit inflation targets they predict. This type of thought always comes to mind with topics in regards to behavioral economics.
Both the survey-based and instrument-based measures of inflation systematically overestimate actual inflation. As Bernanke expressed in his speech, while the Fed does not particularly use expectations to compute short-term forecasts, the models it uses to predict longer-term inflation do use expectations (1). It is logical that expectations should guide actual inflation, because if workers demand wages expecting x% inflation and firms raise prices based on those wage increases, inflation should be near x%. While projections are systematically high, and therefore not an accurate predictor of actual future inflation (2,3), it is possible that the changes in expectations are a determinant of changes in actual inflation. This could be tested by computing the correlation between the percent changes in expected inflation for a certain period and percent changes in actual inflation for the same period (aligning the expectations of and actual for each period). After computing the correlation coefficients between the percent change in core CPI inflation (4) and the consumer expectations survey administered by the NY Fed (monthly, June 2014 to present) (5), the business expectations survey administered by the Atlanta Fed (quarterly, Q1 2013 to present) (6), and the 5 and 10-year TIPS breakeven rates (monthly, Jan 2004 to the present) (7,8), it is apparent that changes in expectations do not guide changes in actual inflation. The correlations of actual inflation with consumer and business expectations -0.27 and -0.57 respectively. That of the 5 and 10-year breakeven point is 0.28 and 0.23 respectively. Also, that there is a continual positive bias in expectations is support against rational expectations as being an accurate model of economic agent’s behavior.
5. “Source: Survey of Consumer Expectations, © 2013-2018 Federal Reserve Bank of New York (FRBNY). The SCE data are available without charge at /microeconomics/sce and may be used subject to license terms posted below. FRBNY disclaims any responsibility or legal liability for this analysis and interpretation of Survey of Consumer Expectations data.”
The reason why consumer expectations for inflation are out of line with other inflations measures probably arise from the behavioral biases that are present in individuals predictions about future uncertain events. First, overconfidence in prediction ability can cause individuals to make bolder predictions than what is warranted in a survey setting (1). Inflation is expected to rise, but individuals may over predict the amount inflation will rise by. Second, the availability bias causes systematic errors in individuals expectation formulations. Individuals will formulate their inflation expectations from price trends in goods where they commonly see the price. This leads to an overweighting of gasoline and food prices in inflation expectations, which is problematic because the inflation measure used by the Fed ignores energy and food (4). The increase in consumer inflation expectations could be explained by the rising gasoline prices (5). Finally, individuals knowledge about inflation may be limited. Since the great recession, individuals have systematically over predicted inflation (2)(3). The systematic over predictions may be evidence that a portion of the individuals in the survey may not be knowledgeable about inflation. The inflation expectations for unknowledgeable individuals would be more regressive than rational.
Over the last two decades, the Fed has been critical to use the traditional rational-expectations model of inflation to determine inflation expectations. Bernanke admits that this model implies that the public is aware of the Fed’s fixed objectives, and that long-run expectations are “anchored” (1). In reality, ignorance, uncertainty, and irrationality contribute to the public’s knowledge of our economic system and inflation rates. Despite, current measures not aligning with their medium-term targets, both former and current Chairs of the Federal Reserve agree that targets will be met. These Fed chairs have determined that expectations will work to get the inflation rate working in their favor, but have disagreed on the reasoning of the expectations themselves. Yellen has said that “inflation should rebound over the next year or two,” mentioning that in 2017 inflation was below their target, and unemployment was decreasing (2). This meant that a price increase would occur in order to follow a standard Phillips curve. Jerome Powell in 2017 has stated that he believes that our current economy follows Bernanke’s idea of people’s expectations being “anchored” and not influenced by cyclical changes (3). This type of reasoning follows the traditional rational-expectations model. From both of these statements, it seems that Yellen has suggested that the public’s expectations are determined by the Phillip’s curve relationship and the public being receptive to information, while Powell has claimed that the public is irresponsive to changes and long-run expectations are generally fixed.
While the Fed’s position on inflation expectations is that they are undeniably influential towards actual inflation, it is still unclear what measures should be taken in order to provide accurate forecasting of expectations. At best, our most parsimonious models still have assumptions that are distinctly different from actual expectations.
According to Ang, Bekaert and Wei (2007) surveys of professionals give much better inflation forecast estimates than market measures do. Consumer expectations, however are much worse than both other measures. Consumer estimate have been consistently higher than actual inflation and other expected inflation measures, and I believe there are a few main reasons for this. Inflation expectations are very slow moving and we have had much lower inflation post-2007 when compared to pre-crisis levels. This could lead to consumers forming their expectation with the pre-crisis environment in mind without realizing it. Another reason could be that the average consumer does not have all of the information or knowledge needed to make an accurate estimate of inflation, while professionals and traders in the market are more informed and knowledgeable. Food and energy are both also a big part of the average person’s consumption so that is likely to affect their expectations of inflation, however the Fed excludes food and energy in the PCE because of its volatility.
Ang, Andrew, Geert Bekaert and Min Wei (2007) “Do macro variables, asset markets, or
surveys forecast inflation better?” Journal of Monetary Economics 54, pp. 1163-1212
Inflation expectations are extremely valuable to the Fed when deciding how to enact monetary policy. As the Fed has previously promised 3 rate hikes for 2018, the newly heated economy has people worried the Fed will increase interest rates at a faster pace. The public typically overestimates ahead inflation rates (Fig 1), and that can have real effects on the economy that the Fed must account for. Higher inflation expectations lead households to save more than previously expected by the Fed, causing ripple effects throughout the economy (increased demand for money, reduced expenditure, etc). However, Mr. Powell has stated that the key to economic stability and steady progress is “gradual normalization” (1). Slow moving shifts in interest rates reduce residual error between the public’s expectations and the actual rate of inflation. Although the Fed knows that the public is anticipating them to “move” at a quicker pace, Jerome might be playing the role of the tortoise in this Aesop Fable. The increased consistency of the Fed’s actions can consequently increase the accuracy of the public’s expectations, and promote more efficient manipulation by the Fed. Also, in the long run, low inflation promotes overall performance of the economy in terms of real growth, which supports employment sustainability (2); knocking out 2 birds with one stone. As Jerome Powell continues a “gradual increase” plan for interest rates, and expectations of increased production in the foreseeable future, as the economy heats up, I see an almost unavoidable increase in inflation past the 2% median target in the next 5 years. Nothing more than 2.75%, but more than 2.000%.
Consumer expectations differ from actual rates of inflation. I think part of the explanation for this is lack of education. People are uninformed and more importantly misinformed about economics and politics. It is mentioned in the article “Ben Bernanke’s Secret Inflation Plan” that politics and elections influence whether or not a fiscal plan involving inflation is talked about. This is because the idea of increasing inflation is generally disliked by the public, which makes officials running for office want to avoid the topic in order to preserve votes. What is interesting to me is that Americans are not only uninformed about the economy but they are just as uninformed about politics. According to Dye and Zeigler’s Quiz of American adults only “28% could name one of their state Senators and 34% new the name of the current U.S. Secretary of State.” After reading through the facts about how the public perceives the economy and politics it is not surprising to me that consumer expectations are off the mark of what actually occurs. As mentioned, it is sometimes difficult to change a consumer’s expectations, especially when many consumers are not well educated on the topic. I think this could also contribute to the slow adjustment of consumer expectations.
There are a wide variety of types of survey-based inflation expectation reports, so to argue that survey-based inflation expectations are inaccurate is simply ignoring that one report may not be an adequate for a comparison to market-based data. Between 2005 and 2008, University of Michigan’s Survey of Consumer Attitudes and Behaviors expected CPI inflation to fall between 3% and 5%, with much monthly variation (1). FRED CPI data indicates that the average inflation rate between 2005 and 2008 was 3.318%, so the consumer opinions were not that far off from reality. The Survey of Professional Forecasters and the Blue Chip Survey are survey-based methods that ask professional forecasters and economists instead of consumers, and both expected that the CPI inflation rate would be closer to 2.4% during the same period, which was a little farther off than the consumer expectations (1). For data from more recent years, the Federal Reserve Bank of Atlanta’s Business One-Year Inflation Expectations, which surveys firms and small businesses in a specific district of Atlanta, have been relatively stable, with an average inflation expectation of 1.91% since January 2016 (3). The New York Federal Reserve’s survey of 1,200 households one-year inflation expectations are a little higher, averaging at 2.64% since January of 2016 (4). The CPI Inflation rate since January of 2016 has an average value of 1.74%, but it has been rising in more recent months (2). The variation between surveys, regardless of accuracy, should be noted: some surveys analyze the responses of the average consumer, some take in data from firms and businesses, and some get input from economists and professional forecasters. The diversity of perspectives and economic situations from where the responses and data originate dictates the differences in expectations. Much can be learned from these surveys, and the type of survey should be taken into account when comparing results between market-based and survey-based inflation expectations, instead of blindly choosing any survey-based report and claiming it inaccurate.
Firstly, much of the general public does not know what the natural rate of inflation is or even what rates of inflation are labeled as “low” and “high” so they are not able to accurately judge future inflation. This strays from the traditional rational expectations model of inflation which assumes that the public has full knowledge of the equilibrium rate and all knowledge that is accessible to the central bank (1). Secondly, the average consumer generally does not take into account inflation in everyday purchases. When a household does consider inflation, those guesses of future inflation are usually based on the more volatile components such as food and energy which a few measurements of inflation tend to weed out, like the core inflation rate (2). This paired with the rational-expectations model, long-run inflationary expectations are not easily changed, despite new information. Mishkin pointed out that inflationary expectations have become better anchored over the past few decades, so even when actual inflation moves, inflation expectations do not move easily and this affects real inflation (3).
Consumer expectations of inflation are essentially throwaway forecasts and differ from other measures of expected inflation for a few reasons. The median consumer is typically not well educated on the concept of inflation, therefore will not take inflation into account when making spending decisions. Households that do care enough about inflation to consider it when making decisions are basing their guess on the unstable components of inflation, food and energy for example, which are neglected by the Federal Reserve in their inflation forecasts. Even in times of financial stability most households do not have a legitimate expectation for inflation which further points to how fruitless this measure truly is. According to a statement by the FOMC in 2017, “ survey-based measures of longer-term inflation expectations are little changed, on balance,” which indicates that the Federal Reserve does review these consumer forecasts but they would more than likely need to observe a significant shift in expectations in order for it to weigh in on their decision making. To conclude, one would be hard pressed to find an inflation forecast that is truly precise but it is also safe to say that consumer inflation expectations are the least accurate out of the possible forecasting options.
The Feds consistently low prediction of inflation compared to market and survey based expectations represent the Feds view that inflation expectations have a significant impact on inflation but is not the only important variable. The low predictions over the past six years likely indicate the Feds prediction that during times of increased economic stability consumers will begin to anchor higher reference points for inflation rates. This could be due to the consumers inability to understand several variables affecting inflation. Formulas such as the Consumer Price Index are very complicated and no one in the general-public would replicate it when making predictions about future inflation expectations. Most consumers make predictions off past rates as well as expectations for future rates. According to Bernanke inflation expectations have become better anchored today but they remain imperfectly anchored (1). Inflation expectations will likely continue to rise above that of the Feds expectations as consumers are unable to make accurate predictions with information available to them. This can be seen in the consistent gap between the Feds and consumer expectations.
In terms of inflation, I believe that the expected inflation rate is not just part of a secret plan from the Federal Reserve to manipulate inflation, but is one of their most effective secret tools. The fact that inflation is recognized as one of the most harmful negative aspects of the economy to even the simplest man is what gives the Federal Reserve power to bring impending fear into the minds of the whole country. In a scenario where the country is in need of a fiscal stimulus and Congress is not in a position to effectively produce expansionary economic policy, the Federal Reserve could simply decide to project the economy to be on route to a worse outcome than before to give themselves grounds to conduct their intended monetary policy. The fact that expectations are so slow-moving also works in the favor of the Federal Reserve, since a sudden jolt in the expected inflation will only indicate a more dire problem that would need to be fixed. Human perception has a strong impact on the well-being of an economy, and as leading Behavioral Economists such as Richard Thaler in his book Misbehaving claim, the individual outlook of a person dictates how they will spend their money. Thus, it is not completely outrageous to claim that the Federal Reserve is in fact playing a game where they are trying to reach economic goals through not only monetary theory, but also through psychological moves to portray any scenario of their choice.
Thaler, R. H. (2015). Misbehaving: The making of behavioral economics.
Arguably the biggest reason consumer expectations of inflation are so out of line with other measures of inflation is because the average person does not know much about the economy. For example, the fed has the dual mandate causing it maintain stable prices and full employment; its target rate is supposed to be 2%. Core inflation – measured by the CPI – has remained roughly at or below the target rate since the end of 2010. The highest inflation has been since the end of 2010 has been 2.3% – with many periods being below the target rate. Data shows that inflation should not be much higher than the target rate as recent history has not shown us otherwise, so it is not reasonable for consumers to expect inflation rates hitting 2.83%. One can try and see how the fiscal policy may have affected these expectations, but as Bernanke says, we should strive to have inflation expectations that are not too reactionary. Yes, our economy is heating up, but the fed will try to stop the economy from overheating by increasing the federal funds rate. The fed is expected to raise rates four times this year as opposed to three. If the economy keeps doing well and better than expected, and inflation rates begin to rise unexpectedly, the fed will raise rates as it sees appropriate.If consumers kept up with the economy and data, they would clearly see that data does not support their claim that inflation rates will be as high as 2.83%.
Consumer expectations of inflation can be affected by many factors, some objective such as the current rates of inflation and unemployment, and some subjective such as the economic conditions of one’s own household, which could address why consumer expectations of inflation are so out of line with other measures of inflation expectations. Since the individual benefit of being informed about possible inflation trends is next to zero, rational ignorance could play a role in consumers not educating themselves enough to make realistic estimates of inflation. In addition, many consumers incorrectly read data on current prices, relying on the CPI rather than “the lesser-known price index of personal consumption expenditures (PCE), which is used to calculate real consumer spending”1. Basing an expectation of inflation on any data that includes food and energy prices is very inaccurate as the Federal Reserve uses the core PCE price index “without the volatility caused by movements in food and energy prices to reveal underlying inflation trends2. Another reason that consumer expectations of inflation may be significantly higher than other measures is due to recent talk of tax cuts, especially of corporate taxes. If people expect to have more money in the future, they may choose to spend more now. While this theory was not supported by George Bush’s tax cuts in 2001 which did not effectively stimulate the economy, it may explain why expectations are higher.3 Individuals may be spending more or anticipating spending more in response to tax cuts and associate their expectations of inflation with their expectations of consumer spending. In Ben Bernanke’s speech at the NBER Summer Institute, he noted that “experience suggests that high and persistent inflation undermines public confidence in the economy”4. Increased expectations of inflation may simply be a result of public unease regarding recent political events.