01.10.07

Economic Trends

Inflation Expectations

Michael F. Bryan and Linsey Molloy

Keeping inflation expectations “contained” seems to be an important preoccupation for central bankers. This is because the expectation of higher inflation induces changes in economic behavior that impose costs on the economy, which, over time, are detrimental to long-term prosperity. For example, when people anticipate an increase in inflation—and the corresponding decline in the purchasing power of their money—they are more likely to invest their wealth in real assets, such as land or commodities. This reallocation is a less efficient use of resources than what may have occured if people didn’t have to seek this inflation-protected form of saving. Rising inflation expectations may also help to perpetuate an otherwise temporary rise in prices, making the job of maintaining price stability more difficult to achieve.

To gauge inflation expectations, economists turn to a number of sources, including surveys of consumers, financial market data, and economists’ predictions. A recent look at each of these sources shows inflation expectations are running anywhere from 2 to 3-1/2 percent, depending on the source and the period over which inflation expectations are projected (1 to 10 years).

Consumers’ year-ahead inflation expectations were elevated in the wake of Hurricane Katrina and geopolitical issues that drove up the price of oil through last summer but have since tumbled downward. Consumers now anticipate that prices will rise about 3-1/2 percent over the next year. Long-term inflation expectations—which have been slightly higher, on average, over the past couple of years—indicate that consumers anticipate that prices will rise about 3-1/2 percent over the next 5 to 10 years as well.

Household Inflation Expectations*

*Mean expected change as measured by the University of Michigan’s Survey of Consumers.
Source: University of Michigan.

One source of data from financial markets that can be used to gauge inflation expectations is a comparison of the returns on Treasury inflation-protected securities (TIPS) and regular (nominal) Treasury securities (click here for data and an overview and here for more detail). TIPS-derived inflation expectations have come down a bit in recent months: Investors now expect prices to rise between 2 and 2 ¼ percent over the next 10 years.

Market-Based Inflation Expectations*

*Derived from the yield spread between the 10-year Treasury note and Treasury inflation-protected securities.
a. Ten-year TIPS-derived expected inflation, adjusted for the liquidity premium on the market for the 10-year Treasury note.
Sources: Federal Reserve Bank of Cleveland; and Bloomberg Financial Information Services.

Meanwhile, the Blue Chip panel of economists anticipates that quarterly inflation will fall dramatically in the fourth quarter of 2006 and average about 2-1/2 percent over the next two years. In light of the relatively sanguine inflation report for November, the distribution of 2007 forecasts has shifted downward a bit. In December, the consensus forecast was for a 2.1 percent annual growth rate in the CPI in 2007, with a majority of forecasters predicting a 2 to 2-1/2 percent rise in the CPI. In January, the consensus forecast ticked down to 2 percent, with a majority of forecasters predicting a 1-1/2 to 2 percent rise in the CPI in 2007.

CPI Inflation and CPI Inflation Forecasts*

*Blue Chip panel of economists.
Source: Blue Chip Economic Indicators, January 10, 2007.

Distribution of 2007 CPI Forecasts*

*Blue Chip panel of economists.
Sources: Blue Chip Economic Indicators, December 10, 2006, and January 10, 2007.