Short- and Long-term Inflation Expectations
Inflation as measured by the Consumer price index (CPI) has picked up in recent months, following increases in food and energy prices. As of May, the annual inflation rate is 3.4 percent. Although some of these increases have reversed course, particularly energy prices, some households and market participants are still worried about an impending inflationary period. Those who are concerned point to the accelerating pattern in underlying inflation measures, such as the core CPI (CPI excluding food and energy prices). For example, the annual core CPI inflation rate increased from 1.0 percent to 1.5 percent from January to May, and near-term (3-month annualized) core CPI inflation increased from 1.4 percent to 2.5 percent over the same period.
Since concerns about future inflation are picking up, it’s a good time to review various measures of inflation expectations. After all, expectations about future inflation are both an important predictor and a factor in future inflation. We will look at near- and longer-term measures from two surveys, the University of Michigan’s Survey of Consumer Attitudes and Behavior (UM) and the Philadelphia Fed’s Survey of Professional Forecasters (SPF). We’ll also look at a measure based on information in market prices (breakeven inflation rates calculated from TIPS and nominal Treasuries) and another estimated from the Cleveland Fed’s (FRBC) model of inflation expectations. Note that for the survey measures, I analyze the median responses for the expectations.
UM 1-year expectations rose sharply in the first quarter of 2011. They rose 1.6 percent during the quarter and reached 4.6 percent at the end of March, following the food and energy price increases. It has long been argued that these inflation expectations series are sensitive to energy prices, and since April, oil prices have declined, as have these expectations. Currently, the 1-year UM expectation for inflation is at 4.0 percent, still about 1 percent higher than its average since 2000.
Short-term SPF inflation expectations increased as well in the last quarterly survey. The median expectation for 1-year CPI inflation rose by 0.4 percent to 2.1 percent, while the 1-year core CPI inflation expectation rose to 1.7 percent from 1.4 percent.
When we look at individual responses in both surveys, we see that the dispersion among UM survey respondents has declined, while the dispersion among SPF respondents has increased. Although about 80 percent of the respondents revised their short-term inflation expectations for both core and headline inflation upwards, the changes are higher in the right tail of the distribution, leading to an increase in the dispersion.
In 2007, the SPF survey began to ask respondents to assign probabilities to the ranges they were predicting for the current and the next year’s annual core CPI inflation rates. In the first two quarters of 2011, the probability they assigned to core CPI inflation ending 2011 between 1.5 percent and 2.5 percent increased. As of May 2011, survey respondents thought that core CPI inflation would most likely be in the 1.5 percent—2.0 percent range at the end of 2011, as they assigned this outcome a 34 percent probability on average. The probabilities they assigned to the 1.0 percent—1.5 percent range and the 2.0 percent—2.5 percent range are 26 percent and 19 percent, respectively. The 1.5 percent—2.0 percent range is also seen as the most likely event for core CPI inflation in 2012, with an average probability of 30 percent. The probability of a 2.0 percent—2.5 percent range in 2011 is 21 percent.
The UM expectation for long-term (5 to 10-year) inflation declined to 2.9 percent in April from 3.2 percent in March and rose slightly to 3 percent in June. Meanwhile, SPF expectations for longer-term inflation have risen. The median of the 5-year expectation rose to 2.4 percent from 2.1 percent in the May survey. The median of the 10-year inflation expectation, on the other hand, ended up 0.1 percent higher at 2.4 percent. However, these increases reflect the convergence of the series to the sample averages rather than an expectation of an accelerated inflationary environment in the long term.
For the longer-term expectations, I also check a number of market and model-based measures. These are the FRBC model’s 10- and 30-year inflation expectations, 5-year and 10-year expectations computed from breakeven inflation rates derived from the spread between TIPS and nominal Treasuries, and the 5-year, 5-year forward expectation based on the same spread. Except for the last one, these measures increased in April and were followed by a decline in May and June. For example, the FRBC 10-year inflation expectation rose to 2 percent in April but declined to 1.7 percent in June. Similarly, the 5-year inflation expectation increased sharply in April to 2.5 percent but declined even more sharply in May and June, ending up at 1.8 percent. In contrast, the 5-year, 5-year forward expectation dropped from 2.8 percent in May to 2.5 percent in March, and then in June it rose back to 2.8 percent. These market measures are subject to different premia such as a liquidity premium, and the 5-year, 5-year measure tries to minimize such effects.
To sum up, near- and long-term inflation expectations appear contained. UM near-term expectations rose and fell with energy price developments in the first two quarters of 2011, while SPF near-term expectations increased, but at far from alarming levels. A core CPI inflation rate of between 1.5 percent and 2.0 percent is still seen as the most likely possibility through 2012 by the SPF respondents. While SPF long-term expectations rose in May, they are now more in line with their historical levels. And finally, though most market and model-based measures of inflation expectations rose in April, they experienced sharp declines in May and June.