Recent Developments in Inflation Expectations
Recent increases in energy and food prices have fed concerns about the prospect of inflation in the near future. While the rising prices of these important commodities are felt by everyone, as two prices among many, they do not necessarily signal impending inflation. For a better gauge of future inflation, we turn to various measures of inflation expectations. Inflation expectations are both a predictor and an important factor in future inflation, and as it happens, most of the short-term inflation expectation measures we have looked at have been rising lately.
Let's first take a look at recent developments. Though the energy-price component of the CPI increased 11.2 percent from February 2010 to February 2011, the 12-month change in the overall CPI was just 2.2 percent. The changes in underlying measures of inflation over the same period were more limited. For example, core inflation (CPI excluding food and energy prices) and the trimmed-mean CPI, a measure provided by Cleveland Fed, increased around 1.1 percent and 1.2 percent, respectively, over the same period. However, these increases in the underlying measures picked up in January and especially in February. In March, the median CPI increased 2.4 percent in annualized terms, and the trimmed-mean CPI increased 3.8 percent in annualized terms, a level it has not recorded since summer 2008. However, these developments have not yet proved to be persistent.
How have economic agents adjusted their expectations for the future following these increases? We check three types of measures: survey, market, and model measures. Survey measures include the inflation expectations from the University of Michigan's Survey of Consumer Attitudes and Behavior (UM expectations) and expectations from the Philadelphia Fed's Survey of Professional Forecasters (SPF expectations). The SPF survey is quarterly and the most recent data were released in February, whereas the monthly UM data is available through March. For the survey measures, we report the median of survey responses. The market measures come from inflation swap data as well as nominal and inflation-indexed Treasury securities. We document the end-of-month figures for these and use the data on March 28, 2011, for March 2011. Finally, model measures are estimated from the Federal Reserve Bank of Cleveland's (FRBC) model, which utilizes the information in the term structure of nominal Treasuries along with the information from inflation swaps and surveys.
Survey measures are divided. One-year-ahead inflation expectations from the UM Survey increased in March to 4.6 percent from 3.0 percent in December 2010. On the other hand, the SPF 1-year-ahead expectations rose only modestly, 0.1 percent, in the first survey of 2011. It seems that consumers pay much more attention to rising energy prices when changing their expectations, as a similar split occurred between the UM and SPF surveys during the summer 2008, when oil prices experienced record highs. The UM Survey's 1-year expectations recorded a 1.2 percent increase between February 2008 and August 2008, arriving at 4.8 percent, whereas the SPF survey increased only marginally from 2.4 to 2.5 percent in the same period. We have to note that CPI inflation in summer 2009, the period for which previous expectations were formed, turned out to be negative.
Market and model-based measures have all increased. The two-year inflation swap rate has been steadily increasing since summer 2010. It was just below 0.9 percent at the end of August 2010, and it ended the year at 1.7 percent. It continued to increase further in 2011 and read 2.6 percent by the end of March. The 1- and 2-year inflation expectations from the FRBC model also increased during the same period, although the change in expectations has been much limited than the swaps data. One-year inflation expectations from the FRBC model rose from 1.4 percent in August 2010 to 2 percent in March 2011. Two-year expectations rose from 1.4 percent to 1.8 percent.
What about longer-term expectations? The expectation for long-term (5 to 10-year) inflation from the UM Survey rose 0.3 percent in March and is now at 3.2 percent, the first time it has been above 3 percent since February 2009. However the 5- and 10-year expectations from the SPF have been quite steady; 5-year expectations increased only 0.1 percent in the last six months and are now at 2.1 percent, whereas 10-year expectations increased 0.1 percent in the February 2011 survey, reversing the decline of November 2010 and resulting in zero change over the course of the last two surveys.
The 10- and 30-year inflation expectations from the FRBC model reversed their downward trends last December and rose to 1.9 and 2.2 percent in March 2011. On the other hand, the market-based measures have showed a significant increase since August 2010. The 5-year, 5-year-forward inflation compensation rate, a proxy for average inflation expectations for the periods between five and ten years in the future, rose from 1.9 percent in August 2010 to 2.8 in October 2010 and has been hovering around that level since then. The rise in the 10-year inflation swap rate has been steadier. It increased around 50 basis points in September and October 2010. It has increased another 25 basis points since then and stood at 2.7 percent at the end of March.
Two important points for these market-based measures should be noted: First, the bigger part of the increase in expectations came between August 2010 and October 2010, around the time the Fed announced that it would reinvest payments of principal on agency and mortgage-backed securities into longer-term Treasuries and there was talk of a possible second round of large-scale asset purchases. In addition, the improved outlook on economic conditions probably accounts for some of the rise in inflation expectations. Hence, it is likely that the recent increases in food and energy prices have had a very limited, if any, effect on these long-term expectations.
The second important point for the market-based measures is that even though they have increased over the last six months, they are currently not far from their historical averages. On the higher end, the 5-year, 5-year forward inflation compensation rate averaged 2.43 percent between August 2004 and December 2007, lower than its level of 2.7 percent at the end of March 2011. However, the average 10-year inflation swap rate was 2.8 percent between August 2004 and December 2007. This average drops to 2.64 percent when one includes the rest of the sample, an effect that is mainly due to the very low swap rates around the height of the financial crisis and the recession. At the end of March 2011 the rate is 2.7 percent. Furthermore, the SPF measures and the estimates from the FRBC model are also lower than their historical averages.
To sum up, all measures of short-term inflation expectations we have looked at show an upward trend since last summer. Some measures showed higher increases (swap and UM survey), and others were much more limited (FRBC model and the SPF survey). Measures of longer-term inflation expectations have also risen in the last six months—UM expectations significantly, SPF expectations marginally, and market-based measures also a lot. However, most of the increase in the market-based measures happened in September and October 2010. The recent increases in food and energy prices have had limited, if any, effect on the long-term expectations. They seem to be well-anchored and are in line with their averages of the previous decade.