Recent Developments in Inflation Expectations
A persistent downward trend in prices has created some concern about whether there will be further disinflation or even a deflation in the future. Here we review what inflation expectations foretell for the future inflation. Since people consider the future level of general prices when they set their own prices, inflation expectations reflect not only their perceptions about the future but they are also an important determinant of future inflation. In addition, there is some empirical evidence showing that the expectations are among the best predictors of future inflation.
One market-price-based measure of expected inflation is the inflation swap rate. An inflation swap is a financial instrument that allows one party to exchange a variable inflation rate for a fixed inflation rate, the swap rate, with another party. The variable rate of the swap we review here is the CPI rate. We also look at the Cleveland Fed’s model-based inflation expectation measure (which utilizes the information in the term structure of nominal Treasuries that is, the distribution of yields on securities of different maturities. For further information about these measures, read Joe Haubrich’s commentary.). One-year inflation expectations from these measures started declining in the spring of 2010. Although there was an uptick in the Cleveland Fed’s August estimate and a smaller uptick in the swap rates, they are pointing to a continued period of disinflation. As of the end of August 2010, these measures reflect an expectation of annual CPI inflation between 0.8 and 1.4 percent.
In addition to these measures, we reviewed estimates of inflation expectations derived from surveys. The first is the University of Michigan’s Survey of Consumer Attitudes and Behavior (the U of M Survey, hereafter), which comes out monthly and asks consumers about the change in prices they expect over next 12 months, without specifying a consumption basket. The second measure is from the Survey of Professional Forecasters (SPF), which is conducted quarterly by the Federal Reserve Bank of Philadelphia. We produce monthly figures by interpolating the quarterly figures. These survey measures have recently shown higher inflation expectations than market- and model-based measures. Further, they have been more stable this year. The median one-year inflation expectation from the U of M Survey is 2.7 percent (as of the end of August) and the one-year CPI inflation expectation from the SPF is 1.7 percent. Despite the fact that these are lower than their long-term average values, they nonetheless indicate that forecasters and consumers assign a very small likelihood of deflation next year.
The SPF measure of one-year inflation expectations has become more uniform across the individual respondents. Furthermore, the lowest individual response for the one-year inflation expectation is 0.5 percent, indicating that none of the individual forecasters expects deflation by the third quarter of 2011.
In addition to asking forecasters for their individual inflation forecasts for different periods, in 2007 the SPF started asking them to assign probabilities to different ranges of inflation. In particular, SPF asks forecasters how likely they think it is that the annual core CPI inflation will be in a particular range in the fourth quarter of the current year and the next year. Their responses show that the average probabilities assigned to the lower ranges of 0.0–0.9 percent and 1.0–1.9 percent for the CPI inflation rate have increased in the last two quarters. The average probabilities obtained in the third-quarter survey for those two ranges for the current year are, for example, 47 percent and 45 percent, respectively.
Similarly, the average probabilities for those ranges for the annual core CPI for the fourth quarter of 2011 have increased throughout 2010. They reached 74 percent together in the third quarter. However, the average probability of the upper half of the 0.0-1.9 percent range is considered as almost two times more likely than the lower half of the range. In addition, although not shown in the chart below, the average deflation probability is 2 percent for this period.
What about long-term inflation expectations? Like short-term expectations, the market- and model-based figures are more volatile than survey-based expectations. They have been declining since April. For example, the five-year breakeven inflation rate declined from 2 percent to 1.2 percent, five-year forward breakeven inflation rate (computed from the five- and 10-year TIPS and nominal Treasuries) declined from 2.8 percent to 1.9 percent between the end of April and August 2010, and the 10-year expectations from Cleveland Fed model declined by 0.3 percent to 1.7 percent in the same period. On the other hand, the 10-year CPI inflation expectation from the SPF survey stayed at 2.5 percent in the same period. However, although not shown in the chart below, the market-based measures of inflation expectations have been steadily increasing since the end of August. For example, the 10-year inflation swap rate increased by 0.2 percent to 2.3 percent, and the five-year forward rate increased by more than 0.4 percent.
Overall, short-term inflation expectations have been lower than their long-term average values. However, they still do not reflect a significant short-term deflation risk. Market-based measures of long-term inflation expectations declined up through the end of August, but they have increased since. Long-term inflation expectations derived from surveys, meanwhile, have been more stable over the year.