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.
20 thoughts on “ECON430-Topic #4: Great Inflation Expectations”
It is important to control inflation because if inflation increases to beyond what is optimal, the increase in prices will “[undermine] public confidence in the economy and in the management of economic policy” (1). Thus, a rise in inflation will contribute to instability in the “public’s assessment of the prospects for future economic stability,” because they expected inflation to be lower (1). However, according to recent studies “the sensitivity of inflation to activity indicators is lower today than in the past” (1). Thus, in the long run, people are not too sensitive to price changes as they used to be and this could be a result of stable monetary policy conducted by the Fed. This insight into the consumer and/or investor mindset is important because it suggests the importance of a credible central bank. In the United States, the Fed has been able to keep inflation low and this may contribute to current expectations. Currently, “consumer expectations for inflation three years ahead fell last month to the lowest level in records” (2). This suggests that people have adjusted their expectations to correspond with previous Fed policies since the Fed has kept inflation low for several years.
However, according to recent information, the Fed may not be the only entity influencing the public’s expectations. The public has learned to utilize and apply current market information when adjusting their inflation expectations. Since prices of commodities have fallen, especially in oil, the reduction in prices may also be influencing public behavior. Furthermore, the appreciation of the dollar has also lowered the price of imports, which suggests that the Fed may not have all the power in influencing peoples’ inflation expectations. Thus, even when Janet Yellen “expects the inflation rate to rise to 2%”, market information may counteract with the public’s expectations, and cause differences between what the Fed wants people to believe and what people actually believe (3).
Inflation expectations formed from the consumer and firm side and by the Fed couldn’t be any more different. Consumers and firms base their expectations more from observations and projections of future costs (per unit costs) and prices of products and services (1). These expectations are formed from more of a practical side and not necessarily based on any complex models like the Fed does. While the Fed uses complicated model of inflation forecasting, they do factor in consumer expectations found by these surveys (2). In order to conduct effective monetary policy, they must be able to manage and shift expectations which gives evidence towards the importance of the surveys of consumer expectations.
Contrary to the survey method, the Fed uses forecasting methods to develop a forecast for inflation and uses intermediate variables such as the fed funds rate to steer the forecast towards their target of 2%. Simply put, these forecasts uses high frequency inflation measures such as TIPS breakeven and inflation swap rates to formulate a forecast of inflation (3). From this the Fed observes the forecast and steers policy towards changing that forecast. Forecasts are going to be wrong, and the best forecasts are the ones that are the least wrong by working towards achieving the last amount of “loss” by minimizing the forecast’s loss function. Interestingly enough, the Fed’s forecast shows convergence to the 2% target by 2018, with the forecast at a flat 2% in the long run (4).
Even though the process by which we develop expectations of inflation differ dramatically, market-based measures seem to outperform survey based measures. This is because consumer surveys always overestimate anticipated inflation relative to market-based measures (5). Evidence of this is shown by the NY Fed’s Survey of Consumer Expectations, which shows inflation expectations of around 3% for the last two years or so (6). On the hand, inflation expectations in the bond market by investors continues to fall, down to about 1.66% (7). all this revolves around the Fed’s target of 2%. While there is opposition to these complicated models to forecast inflation, they are more accurate measures of future inflation. With all this being said, it may still be the case that the best guess for inflation in the future is simply what it is today.
Consumer expectations of inflation diverge from other measures of inflation expectations due to a few different reasons. To start, it is important to note that consumers’ understanding of the economy is extremely limited, especially when being compared to professional investors and firms. Most Americans lack proficiency in “fundamental economic principles such as the workings of inflation, risk diversification, and the relationship between asset prices and interest rates (1).” Additionally, consumers most likely update their information at intervals, as opposed to continuously (2). Further, without any incentives, consumers may not take the time to formulate their best estimate when responding to a survey – which leads to bias and “noisy” responses (3).
This does not mean, however, that consumer expectations are not important. A study in 2011 found that “the beliefs elicited are generally consistent with the decisions of the respondents (3).” This is why it is important for the Fed to try to shape expectations. The public’s expectations about monetary policy in the future have effects on today’s financial state which leads to effects in output, employment, and inflation (4). One of the Fed’s instruments used to shape expectations is “forward guidance”, coined by the Bernanke Fed (5). It is “the use of communication about future central bank actions to influence present behaviour(6).” To work effectively, the Fed needs to have credibility to help “anchor” inflation expectations “hence central bankers should not change their statements too often (7).” If the Fed is credible, it would lead to a self-fulfilling prophesy where agents expect a certain level of inflation and then raise their prices accordingly “and thus transform their expectations into reality” which further reinforces their expectations (7). This would explain the Fed’s “thinking” about expectations when Janet Yellen says she believes inflation will meet its medium-term target of 2%. There is no doubt that she is aware that the surveys do not match up with this, but by making an announcement about the inflation rate, she is hoping to influence and change the public’s current inflation expectations about the future.
Inflation is falling and appears to continue falling. This is evidenced by the 3 year expected inflations rate dropping, and how the 1 year expected inflation rate is consistently below the 3 year rate (1). This is also consistent with the Treasury breakeven point at 1.49 percent, which is below the Fed target of 2% inflation, and is the lowest since May 2009 (2). However, some may think these numbers are not as accurate as we think. In terms of the Treasury bond TIPS breakeven point, the numbers may not be accurate because it has only been around since 2003, so there is little data to make an accurate forecast (3). The median consumer expectations survey is flawed because many people asked probably have no idea what is going on in the economy, or how things would change the inflation rates. The actual inflation numbers calculated by the Fed still show inflation rates are far below the average of 2%, but this has a lot to do with outside forces.
A central bank could do everything perfectly correct in terms of monetary policy to keep inflation at the rate they want, but if other countries are changing that have effects on our economy, the inflation rate cannot stay at the goal. This is what is happening currently, as the dollar has appreciated relative to many other countries, due to things like dropping oil and energy prices (2). These effects are only short term effects, and one would expect their currencies to eventually appreciate in the future as well as commodity prices increase past their lowest in years, which will raise the inflation rate of the U.S (4).
Despite the inflation rate clearly dropping lower than expectations, Janet Yellen still believes inflation will be at 2% in the medium term. This begs the question, are the top economists in the world completely ignoring the obvious trend in inflation rates and acting completely erratically, or is there more to the story? The answer is obvious; they know what they are doing. The first reason they say this is because they take into account the regression theory in paragraph two, which will raise inflation rates(5). The next reason is to adjust people’s expectations. The majority of people have no idea what influences inflation rates, so they take the word of experts (the Fed). If the Fed says inflation will be 2%, most people will assume they know what they are talking about and will adjust their actions accordingly, which will in turn actually lead the inflation rate to 2% (6). Basically, assuming the Fed is credible, whatever they say they think inflation will be, inflation will actually be. This explains Janet Yellen stating inflation will still be at the goal of 2%, despite a trend moving away from 2%, she truly expects by saying this inflation will reach the goal of 2%.
(5) Neveu Lecture 11.
Survey and market based methods for measuring expected inflation are compared by considering how close those forecasts where to what actual inflation ended up being (2). A study by Kliesen showed that market based data was 34 percent more accurate than household measures of inflation expectations (1). However, Kliesen only tested the accuracy of one market based test (BEI 5Y5Y) and one survey of households conducted by the University of Michigan. This is misleading because the BEI 5Y5Y has only been operating for a short period of time, so there is little data (3). Other studies, that consider other survey and market based measures, show that survey based forecasts “outperform the other three methods in forecasting inflation. (4)” Similarly, a study by the Federal Reserve Bank of San Francisco, found that survey-based forecasts performed the best, possibly because professional forecasters can incorporate all the information at their disposal (2). Still, both households and professional forecasters have been shown to put too much emphasis on current inflation when making their forecasts (6).
Consumer survey data on inflation expectation reflect consumer attitudes about their economic or financial situation. If an individual is struggling financially he may attribute some of that to rising prices, therefore, higher inflation expectations could mean people expect poor economic conditions in the future and vice versa, adjusting their pricing and wage decisions (7). This can be seen clearly in surveys like the SPF that also collects survey forecasts on expected unemployment, job gains, and the risk of a negative quarter. The most recent data showed that forecasters expected less unemployment (5.1%-4.9% in 2016:Q1), more job growth (185,100 – 188,200 in 2016:Q1), and less risk of a negative quarter (13.7% – 13.0% in 2016:Q1) while decreasing their expected inflation (6). (Headline CPI expectations fell from 2% – 1.8% in 2016:Q1, Headline PCE expectations fell from 1.7% to 1.6% in 2016:Q1)
Consumer inflation expectations are lower than the Fed hopes for inflation to be and are decreasing. Some believe that the recent drop in inflation expectations is because of the recent drop in oil prices (1). Researchers have found that U.S. citizens in particular heavily base their inflation expectations on the price of oil (2). Perhaps seeing the fluctuating price of oil daily on billboards is a constant reminder to American citizens that prices are changing, where as other prices tend to change over longer periods of time. Other researchers have found that many people base their inflation expectations on other factors, such as expected financial difficulties, attitudes towards major purchases, or expectations of future nominal income (3). Although these factors may affect the spending patterns of the individual person (i.e. if someone buys a car they are unhappy with, they may choose to spend less in the future), they do not necessarily directly affect inflation as research has shown many believe they do. Consumers also tend to view inflation as an inherently bad thing and ignore inflations short-term benefits (4). Low consumer inflation expectations could be caused by positive consumer outlooks of the economy. Factors such as these that are not taken into account by market-based measures of inflation expectations may explain the discrepancies between market and consumer inflation expectations.
According to the Fed the FOMC considers an inflation target of 2% annually is best for the dual mandate for price stability and maximum employment (1). However, this number is essentially arbitrary. Larry Ball makes the case that a 4% inflation target would better serve central banks as they decrease the likelihood of hitting the zero lower bound giving the central bank more wiggle room without harming the economy significantly (2). When the Fed began inflation rate targeting in 2012 they could essentially picked any number, within reason. Yet, the difference between inflation target, expected inflation, and actual inflation can have real effects on the economy.
There are many theories that argue against the Fed’s discretionary based policy, many of which speak about conspiracy like actions taken by the Fed and the government trying to steal purchasing power away through an inflation tax (3). The below 2% target inflation expectations on the 10 year breakeven rate, currently at 1.6% (4), could reflect the current low inflation rate and FOMC expectations released earlier this year (5). However, even taking into consideration lagging expectations, the real inflation rate hovering around 0.4% causes concern for that assumption. Why do expectations remain 4 times as high as the current rate when it has undershot the target for 40 consecutive months (6)? Maybe it is possible that the public’s long term inflation expectations are anchored, as Bernanke suggested (7), close to what the Fed has targeted simply because people have to believe in something. The majority of people surveyed in 2014 could not identify Janet Yellen as Fed chairwoman and only could offer a basic grasp of what the Fed actually does (8). The long and short of it is if economists can’t agree on one thing, how is the public supposed to form opinions on almost any economic factor? With competing, and often confusing, opinions and theories being presented the public has to put their faith in something- why not the Fed?
The theory that the Fed wants to raise inflation in order to pay off its debts more cheaply at the expense of consumers’ valuations of assets is held by anti-government citizens like Rand Paul (1). Here are a few reasons as to why inflation is targeted and why this view is hysteria.
First, in a liquidity trap, this is usually the other way around. Debts are purchased and used to induce belief of future inflation in the people (2) instead of inflation being used to cover debts. Second, inflation combined with higher output increases government revenues so they can meet their expected budget (3).
Given the difficulties in raising inflation and the lags that slow policy goals, opponents of inflation may see announced target changes as too harsh, and overreact given that announced targets aren’t necessarily REALLY what the Fed is targeting (4).
These are very important goals to reach that improve the nation and are helped by inflation. Given the complex models used by the Fed, it’s kooky to assume they would be using these as a front to some diabolical plan.
“While the unemployment rate remains at 5 percent, the broader U-6 labor-impairment rate increased a tick to 9.9 percent. That points to a lot of discouraged workers and far too many part-time workers. It’s also a key reason why 63 percent of Americans think the country is moving in the wrong direction” (1). This percentage of American believing the economy is going in the wrong direction, could get in the way of the fed reaching its 2% target inflation rate. The fed thinks inflation expectations matter because it helps influence what inflation does in the future in response to consumer investment and spending. “Investors expect the U.S. inflation rate to be running at an annualized 1.66% on average within a decade, and U.S. consumers expect the inflation rate to be running at 2.8%” (2). These expectations come from the lower commodity prices, and appreciation of the dollar, which provides the expectations to differ from the Fed’s target goal. Although unemployment is at an all-time low, wages have still not had any significant increase. So, with consumer and investor expectations differing from the Fed’s target, it could still be wise to hold off on policy adjustments to see if wages increase and economy continues to strengthen. By holding off the Fed does not expect inflation to suddenly jump from 1.5% to 4% or 5% given our current environment (3). So, Yellen and the Fed do not see inflation expectation to change even if the current rates turned around to start increasing. So, markets expect inflation rates to remain below the Fed’s target at breakeven rates, and believe that an increase in interest rates should hold off to continue seeing how the market responds (3).
Inflation is often referred to as a tax on money holdings. Consumers take inflation into account when they make important financial decisions. But what’s more important than what inflation is today, is what it will be in the future. Therefore there’s a need for tools to measure and predict inflation. Measuring inflation is hard, but predicting it proves to be almost impossible. What the real inflation rate will be; what consumers think it will be; and what the Fed thinks it will be are often completely different. Consumer’s beliefs about future inflation expectations consistently fall short of what the Fed has accounted for, and there are several reasons for that.
The Fed’s primary job is to balance economic growth with inflation; while simultaneously striving for maximum employment and price stability (1). In general the public has negative feelings towards increasing inflation due to fear of hyperinflation, and that inflationary periods are no fun at all. This cold feeling towards inflation make consumer expectations bias. However even though the Fed has more insight as to what will actually happen, by measuring and making the forecast public information will inevitably change the real future interest rate.
Janet Yellen has stated she believes the Fed will reach its target of 2% in the medium run, but the Fed is aware that it’s predictions effect general belief. What’s more the Fed knows long-term forecasts don’t take into account important factors like exogenous supply shocks. In general long-term inflation expectations are inaccurate (2), so it would make sense to use this release of public information strategically to have a better chance of reaching the target. Consumers expectations have been trending down for years and are at a disturbingly low level (to the Fed). This has sparked a debate among monetary policy makers whether or not to raise interest rates (3).
Due to exogenous shocks like falling oil prices and appreciation of the US dollar—inflation is consistently falling. The Lucas Critic would imply that only random behavior on the Fed’s part could possibly effect inflation, and it is a well-known fact that inflation is often an indicator of the previous period and exceedingly difficult to predict and manage. With that in mind the Fed very well may still hike rates despite the recent drop in inflation (4).
Most measurements of inflation expectations are flat out wrong and effect consumers negatively in the worst case, and lagged a period making them irrelevant in the best case (1). Inflation is what it is and there may be no way the Fed can change that. However that won’t stop them from trying even if it means revealing a doctored prediction to the public in order to achieve its aim.
Expectations can be fickle. While sometimes close, when it pertains to expected inflation consumer expectations have been different than real inflation. However, this could be good and in fact the Fed wants expected inflation to rise higher so they can raise interest rates. So having higher expected inflation will lead to higher actual inflation. Therefore the Fed has tried to impact expected inflation by continuing to state their target rate and to stand firm in the belief that this target will be met. The problem lies with trying to affect consumer inflation expectations. Lack of awareness by the general public of the actions and objectives of monetary policymakers is making it difficult for the Fed to guide expectations (1). With consumers not knowing the goals of the Fed them announcing their plans is not doing much good. The financial markets are different and have better estimates of inflation, but when discussing households the message is not received.
Recent surveys have shown record lows in consumer inflation expectations and an overall downward trend the last two years (2). Three year expectations for October are roughly 2.8% which is down from 3.4% in June 2013 (3). Even will the decrease in inflation expectations the survey-based measures are still much higher than actual inflation which is close to 0.3% – 0.5% using the Fed’s PCE measure of inflation (4). As previously discussed the reason for the wide spread is due to the general public not knowing what is going on with monetary policy. Monetary policy can be difficult to understand so full disclosure of the Fed’s target inflation may not have much effect on the general public. Therefore “anchoring” inflation may not actually work and the Fed may not be able to effectively change actual inflation through consumer inflation expectations.
Over time, the Fed has made attempts to manipulate public expectations to reach their target level of inflation. What has become increasingly apparent, however, is that because expectations vary over time, it is nearly impossible to create a model that can act as a true predictor.
One of the largest problems in creating a model to reflect inflation expectations is the fact that expectations are not “anchored” and thus, cannot demonstrate a true predictor in a real economy (1). Because there is no one sole factor that is anchored to expected inflation, one cannot effectively create a policy that will have a definite long-term effect. Robert Barro and David B. Gordon state that an unanticipated change in policy is the solution to gaining a desired effect, since individuals will adjust their expectations if there is a change in policy (2). In spite of the effects that an unanticipated policy can have in the short run, the unanticipated nature of it makes it impossible for it to be systematic and as a result, cannot be used as a solution (3).
Another problem in the creation of these predictors is the lag in an effect from policy changes. The adjustment of prices and wages are “sluggish” in response to policy changes (4). The lag in an effect allows time for changes in expectations, creating another unknown variable when trying to measure inflation expectations.
Many macroeconomic models assume that “people share a common information set and form expectations rationally” (1). However, in reality this assumption does not hold as evidenced by the variation in different measures of inflation expectations.
Consumer expectations of inflation as measured by the New York Fed Survey of Consumer Expectations currently stands at approximately 2.8% for both the 1 year out and 3 year out inflation rate (2). This measure is much higher compared to the Survey of Professional Forecasters estimate of 1.8% in 2016 (3). Both of these measures differ from market based measures such as the 10 year breakeven rate which currently stands at 1.56% (4).
The difference in these measures is because everyone does not have the same information and understanding of the information (5). Another reason is the fact that people have different incentives for coming up with correct forecasts (5). For example, investors who have mass amounts of money tied to their prediction have a greater incentive to get this prediction right as compared to an average American citizen who responds to a survey. Not only do they have a higher incentive, they also have a better understanding of the topic and information, therefore their forecasts will differ from that of the average survey respondent.
Since inflation expectations influence many economic decisions, monetary authorities are very concerned with managing these expectations (5). Ben Bernanke noted that “Policy makers would like to better understand the formation of inflation expectations in order to improve their inflation forecasts and the resulting policy choices” (6). Although these expectations do not exactly align with the Fed’s 2% target and seemingly have not risen as a result of the Fed’s confidence that inflation will return to 2% over the medium term, changing their statement has the potential to undermine their credibility and therefore overall policy effectiveness (7). Standing firm and confident might do a better job in guiding expectations than openly stating that they are unsure about the future of the economy, specifically inflation.
1. DISAGREEMENT ABOUT INFLATION EXPECTATIONS (Mankiw, Reis, Wolfers) http://www.nber.org/papers/w9796.pdf
Managing inflation expectations is a difficult task for the Fed that can have real economic consequences if done properly. However, there are issues that the Fed encounters when trying to convince consumers and investors to expect a certain inflation rate.
Firstly, many consumers do not follow the Fed’s actions closely and have different perceived levels of inflation than are actually occurring. A June 2015 CNBC survey found that consumers had significantly higher predictions for inflation over the next year, with the median forecast at 2.8% (1). This is higher than the Fed’s prediction in their own June 2015 meeting where they acknowledged “inflation would continue to run below the Fed’s target of 2% from now until the end of 2017” (1). Of the individuals surveyed, 15% thought inflation would be greater than 11% over the next year. A big reason for this difference in consumer versus Fed inflation expectations is the rising cost of services, such as cable bills (+13.7% from May 2010 to May 2015), versus the falling prices of some consumer goods, such as televisions (-57.7% from May 2010 to May 2015) (2). Because consumers pay their cable bill at a much more frequent rate than they buy a television, they feel that prices are increasing by more than reality shows.
A second issue the Fed faces when trying to set inflation expectations is managing federal funds rate policy. The Fed has been saying for many months that they will ‘very likely’ raise rates at their next meeting. Before each meeting, articles appear claiming that this is the time the Fed will truly raise rates (3). However, the past several meetings have left many economists disappointed at the Fed’s inaction. A big part of the reason the Fed has refused to raise the federal funds rate is the slower than expected inflation compared to Fed targets (4). Inflation has been steadily below the Fed’s target of 2% over the last few years and there is no indication that it will improve anytime soon (4). The Fed cannot keep claiming it will raise rates if inflation continues to be low, as a rise in rates will hurt inflation growth, not help it. Their credibility is being damaged each time they refuse to raise rates and consumers are not as likely to adjust their expectations when the Fed claims they will make a new policy.
(2) http://si.wsj.net/public/resources/images/NA-CG468_OUTLOO_16U_20150712143010.jpg Source: Labor Department
The factors that drive expected inflation rates currently depend on analysis that looks at survey-based measures, market-based measures, and predicted model results. Survey-based measures are conducted by the University of Michigan Survey Research Center. They ask consumers their expectations for the Consumer Price Index (CPI) inflation rate over the next five to ten years (1). Market-based measures are driven by the breakeven inflation rate (BEI), which is the difference between the nominal yield on U.S. Treasury securities and inflation-indexed Treasury securities of a comparable maturity (1). The “5-year, 5-year forward” (5Y5Y) breakeven inflation rate measures CPI inflation expectations for the next 5-year period, beginning 5 years from now (1). Kevin Kliesen’s analysis of accuracy is based on the annual compounded annual rate of growth in the CPI between January 2003 and September 2007 (2). In January 2003, the Michigan survey-based measure of 5-10 year expected inflation rate had a mean value of 2.89 percent (3). The market-based measure had a mean value of 2.40 percent (3). The observed inflation rate had a mean value of 1.81 percent between January 2003 and September 2007 (3). The market-based survey measures, using the root mean squared error in the statistical results, were 34 percent more accurate relative to the survey-based measures (1).
The statistical results of Kliesen’s analysis provide insight into the discrepancies between survey and market-based measures. Consumers had a tendency to overestimate inflation more than the market expectation and this might be driven by consumers being more sensitive to the price changes in the goods they buy and use towards production. Kliesen writes that policymakers and professional forecasters should use market-based measures to derive inflation expectations, as they are more accurate than survey-based measure (2).
While survey-based measures may be less accurate in their forecasting ability, the results from consumers may provide more insight into the fundamental state of aggregate demand in the economy. Since firms and households are sensitive to the real value of expenditures, their expectations may provide policymakers with additional information that supply and demand analysis in the financial markets cannot quantify. From Kliesen’s analysis, consumers were on average expecting greater prices changes, relative to the market approach, in the next five to ten years. This result may have real effects on future economic activity. For example, a firm who expects greater price changes in their inputs may find it beneficial to lower their production capacity to reduce costs. These changes in aggregate could create additional effects in the economy that the breakeven inflation rate may not be able to forecast. Understanding the changes in behavior due to higher inflation expectations by firms and households could provide policymakers with more valuable information compared to market-based measures
October 2015 marked the 42nd month in which U.S. inflation was below the fed’s target rate of 2% (1). Consumer expectations for inflation are out of line with the feds target, “The median respondent to the New York Fed’s October Survey of Consumer Expectations predicted annual consumer price inflation three years from now would be 2.78 percent, down from 2.84 percent in the September poll( 2).” Inflation has been so low for so long that it makes sense that consumers are hesitant to believe that the Fed will increase interest rates resulting in higher inflation. This uncertainty is evidenced by Ramesh’s findings in that, “while analysts believe the Fed will finally raise rates on Dec. 16 after taking a pass several times this year, they are not convinced the Fed will have the proof it needs to hike rates more quickly than even the most gentle of scenarios (3).
The move towards higher rates continues to weaken consumer expectations for higher inflation with comments made by Yellen saying she is “looking forward” to the day when the central bank increases interest rates (4). These comments were made this December and most likely imply that it is difficult for the Fed at this time to move consumer expectations from its current low levels.
Modern economic theory uses expected future inflation to calculate actual inflation, mainly because our expectations of the future affect the decisions we make today. The goal of the central bank is to provide a low and stable inflation such as the 2% long term inflation rate. This is the reason why accurate inflation expectation values are so important. Inflation expectations are calculated using two main sources of information: survey-based measures of inflation expectations and market-based measure of inflation expectations. In survey-based measures of inflation expectations questions about future inflation are asked to consumers and professional economists while market-based measure of inflation expectations are calculated from the prices of financial securities (1).
Both, survey-based measures of inflation expectations and market-based measure of inflation expectations are used by central banks to regularly analyze inflation outlook. This information helps in the consideration of monetary policies. However, the accuracy of both measurements can be uncertain. In the long-term inflation expectations policymakers and forecasters should concentrate in market-based measure of inflation expectations because they are more accurate than survey-based measures of inflation expectations. Kliensen (from the Federal Reserve Bank of St Louis), finds that in 5 years inflation expectation measurement survey-based measurement was 49 basis point higher than market-based measurement and more than 100 basis points over actual inflation. (2) If we concentrate in short-term inflation expectations (1 to 2 years ahead) survey-based measures of inflation expectations are more accurate than market-based measure of inflation expectations. Bauer (from the Federal Reserve Bank of San Francisco), finds lower accuracy on the market-based measurement than the survey-based measurement (3).
While it does not seem likely that there is a plan to sabotage the American people by the Fed in manipulating inflation rates (2), the Fed does have control over interest (1). It does not appear that the Fed is a devious body, but that being said, the Federal Reserve has a strong control over interest rates for the country, so that power alone gives them the keys to the economy, and since all humans are subject to error, it is possible they can negatively influence the economy. With the ability to determine interest rates, whatever method the Fed uses in predicting inflation and taking preventative action, will be very important.
According to the previous Chairman’s own article, inflation rate expectations largely determine what actions the Federal Reserve takes, saying, “the state of inflation expectations greatly influences actual inflation and thus the central bank’s ability to achieve price stability” (1). The Central Bank relies heavily on the expectations of inflation in determining their policy, but in doing so, they can create a self-fulfilling prophecy. Additionally, an academic article published in Journal of Money, Credit and Banking also agrees that “Policymakers and financial market participants tend to pay close attention to surveys of expected inflation” (3). With these forecasts, people will plan to invest in stocks, take out loans, or consume a number of other things that are positively affected.
The inflation rate is monitored so closely by the Fed and many investors because the negative consequences of low inflation, or deflation, can be nearly as bad as inflation (1, 4). When inflation occurs it “undermines public confidence… [and decreases] risk-taking, investment, and other productive activities” (1). This will make it so people are reluctant to interact with the economy because whatever they buy will be worth less and it will cost more. Alternatively though, the biggest problem with deflation or such low inflation is that prices will fall. While alone that may be a good thing, but what happens is when those prices fall wages of
workers fall along with them (4). This has a ripple effect that makes people less apt to buying consuming or working if wages are so low. However, as Bernanke’s article points out, “in the long term, low inflation promotes growth, efficiency, and stability” (1). This means that the low rates are a good thing in the long run, but in the short-term it could lead to jobs being lost and a subsequent negative ripple in the economy.
With that though, since these inflation expectations are so important in determining monetary policy, one would expect them to be extremely accurate, but they are not (3). While “survey measures of expected inflation provide better forecasts than a wide variety of alternatives,” they are still wildly inaccurate. Even though the ‘survey measures’ are more accurate than many other types of inflation forecasts, since 2008 all of the forecasting has become less and less accurate (3). What is a paradox about this idea is that even though the forecasts are inaccurate, the same academic study suggests that people and economic professionals still place a huge amount of importance on these inaccurate forecasts.
All in all, it is difficult to come up with a solution to these problems because, not only are they deep rooted in decades worth of trial and error, but they also have merit. The Federal Reserve, in theory, is an absolutely great idea, a financial body separate from the government and out of their control, but when put into practice, they are human and capable of error. Also, since they do not have federal oversight, they can make errors and ill-informed decisions that harm the economy without suffering really any consequences.
Lastly, as previously stated, the Fed can create self-fulfilling prophecies based on bad data by following these expected inflation rates. If they respond to expected rates by lowering or raising interest, but the expectations were inaccurate to begin with, that means that the Fed can
either be creating the trends, or can also be negatively swinging interest rates, and possibly inflation itself.
(3)Trehan, Bharat. “Survey measures of expected inflation and the inflation process.” Journal of Money, Credit and Banking 47, no. 1 (2015): 207-222.
A potential explanation for the discrepancy between the public’s expectations of inflation and other measures is the misguided assumption that consumers form expectations of inflation rationally. The rational-expectations model of inflation suggests that people predict the future based on past experiences and all available information (1). A longstanding economic theory is that humans are utility maximizing and that they do indeed act rationally; but what if that assumption was incorrect (1)? In the complete absence of rationality, it is possible that inflation would never (or very slowly) reach its long-run equilibrium rate due to the fact that actual inflation would never equal expected and consumers would be content with constantly making inaccurate inflation predictions. Despite this imprecision, consumers would only barely adjust their expectations of future inflation. This theory that the public does not predict inflation rationally would lead to very slow-moving changes in expectations and would support the observation that consumers’ expectations often are not aligned with other measures.
It is also possible that humans are in fact inherently rational decision makers but simply do not have the means by which to make accurate inflation forecasts, causing their expectations to diverge from other metrics (2). The average citizen arguably does not have a profound understanding of monetary policy or of the economic system in general, which could, despite their best efforts, cause their expectations of inflation to be consistently inexact. Therefore, one could also argue that the discrepancies between consumer predictions of inflation compared to other measures is rooted in the possibility that humans, in spite of their inclination to create rational and informed predictions, simply do not have the knowledge or understanding to arrive at the same forecasts as other metrics.
Comparing market and survey-based measures of expected inflation maybe difficult, but this is a worthwhile endeavor. Determining how to measure inflation expectations is crucial in aiding the Fed with how to best carry out inflation target plans. Two primary measures of inflation expectations are market-based measures, and survey-based measures. At first glance, it might seem like no trouble to simply compare the two, however, it is important when comparing these measures that market based expectations “are not reflections of pure inflation expectations,” they “also reflect inflation and liquidity premiums” and recent volatility in the financial markets could have easily affected these premiums (1). Another thing to consider when comparing market indicators with survey results is that the relationship between the two can create a sort of vicious cycle. While market indicators are taking additional factors under consideration to calculate expected inflation, “if market-based inflation-expectation readings continue to stay at very low level, it could influence the reading from survey-based data” as well, thereby lowering survey based inflation expectations (2).
According to the Federal Reserve Bank of San Francisco, “market-based inflation expectations are ‘poor predictors of future inflation’” when compared against surveys of professional forecasters or other constant measurement tools (2). Furthermore, they argue that “the market-based measures ‘contain little forward-looking information about future inflation’” (2). This is a pretty significant problem to consider, given the seemingly inherent forward-looking nature of expectations for the future.
Not only are survey based measures argued to be more accurate and more representative of the public’s inflation expectations, they can also include additional relevant insights- specifically the consideration of lagged inflation values. In previous models of estimation, “the estimated coefficients on lagged inflation almost certainly reflect to some degree the formation of inflation expectations and their influence on the inflation process” (3). Unfortunately, this consideration is often hard if not impossible for the FRB to utilize due to susceptibility to the Lucas Critique (3).