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. Lately, inflation expectations have been lower than the Fed’s target rate of inflation, and are continuing to decline. Three-year inflation expectations (as measured by a consumer survey) are down below 3%, which seems high considering what current rates of inflation and compared to other measures of expectations. One-year inflation expectations, in the Atlanta Fed’s firm-level survey-based measure, are around 1.8%, and the Cleveland Fed’s model of inflation expectations are hovering below 2% per year for the next ten 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) “the 10-year breakeven rate narrowed to 1.49 percentage point, the lowest level since May 2009. It suggests investors expect the U.S. inflation rate to be running at annualized 1.49% on average within a decade, way below the Fed’s 2% target.”
Recent measures of actual inflation reported in the Wall Street Journal have been very close to 0.3-0.5% using the Fed’s PCE measure of inflation, now at over 40 consecutive months of inflation undershooting the Fed’s target for medium term inflation. The Cleveland Fed also reports that measures of inflation are at around 1%, rather far from the Fed’s target, and CPI measures are down below 1%. 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 has mentioned that she believes 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.