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Short- and Long-term Inflation Expectations

Annual inflation as measured by the Consumer price index (CPI) has declined in each month since September, following decreases in food and energy prices. As of November, the annual inflation rate is 3.4 percent. Despite this reassuring signal in the wake of the first half of the year, when the CPI was increasing, some households and market participants are still worried about an impending inflationary period. Those who are concerned point to the upward trend 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 2.0 percent from January to August and then continued to climb, reaching 2.2 percent in December.

Annual Inflation

Here we review various measures of inflation expectations, because expectations about future inflation are both an important predictor and a factor in future inflation. We look at results 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). First, we look at near- and longer-term measures of inflation expectations from both surveys, focusing on the median responses. Then, we turn again to the SPF, looking this time at the likelihood that participants assign (on average) to various ranges of inflation rates for this year and 2012.

In general, near- and long-term inflation expectations appear contained. Both UM and SPF near-term headline CPI expectations started to decline in the second quarter of 2011 and continued to decline through the end of this year. During the second half of 2011, SPF long-term expectations have increased slightly and are now more in line with their historical levels. SPF respondents expect to see core CPI inflation between 1.5 percent and 2.0 percent in 2012.

Survey One-Year Inflation Expectations

Inflation expectations from consumer surveys, like the UM 1-year expectations series, are sensitive to energy prices. Starting in April of 2011, both gas prices and the UM 1-year measure of inflation expectations started to decline. They continued to decline through December, when the expectations measure bottomed out at 3.1 percent. While still slightly higher than its average since 2000 (3.0 percent), the UM 1-year expectation currently sits 0.3 percentage points lower than it did at the beginning of this year and 1.5 percentage points lower than its peak in April.

According to the SPF measures, short-term inflation expectations decreased from the third to the fourth quarters of 2011. Over this period, expectations for 1-year CPI inflation ticked down just slightly to 1.97 percent from 2.0 percent, while expectations for 1-year core CPI inflation stayed at 1.8 percent. Currently, these two measures of expected short-term inflation are more in line with each other than they were during previous quarters, when they followed roughly the same path but did so at different levels (the CPI stood about 0.3 percentage points above core CPI from 2011:Q1-2011:Q3).

The reason for this dispersion between SPF expectations for the CPI and the core CPI—and also for the second-quarter peak of the UM measure—was some forecasters’ reaction to rising energy prices during the spring. As energy prices rose, short-term expectations for the CPI adjusted to a higher level. Expectations for the core CPI did not adjust in a like manner because the core CPI excludes energy prices. This also explains why expectations for the core CPI did not fall with energy prices through the second half of the year, like those for the CPI did.

In 2007, the SPF began to ask respondents to assign probabilities to the ranges of annual core CPI inflation rates they predict for the current and the following year. These probabilities are assigned anew each quarter.

We turn first to these predictions for 2011. As of November 2011, survey respondents thought strongly that core CPI inflation would most likely be in the 2.0-2.4 percent range at the end of this year, as they assigned a 52.3 percent probability to this outcome. This is the highest probability assigned to this range over the past four quarters. In the second and third quarters of 2011, the average survey response expected lower inflation—between 1.5 and 1.9 percent—assigning to this range probabilities of 34.2 percent and 38.2 percent, respectively. In the first quarter, the average survey response expected the lowest range of core CPI inflation rates, with a probability of 18.5 percent.

As for current expectations of inflation for 2012, inflation between 1.5 percent and 1.9 percent is seen as the most likely outcome for core CPI inflation, with a probability of 31 percent.

2011:Q4 Core CPI Probabilities
2012:Q4 Core CPI Probabilities

The UM expectation for long-term (5- to 10-year) inflation declined to 2.7 percent in October and held that level through December. The drop to 2.7 percent was a slight one from 2.9 percent, which was the level the measure had held firmly since July. In June, the UM expectation rose slightly to 3 percent from 2.9 percent in April. The UM expectation hit its 2011 peak, 3.2 percent, in March.

Meanwhile, SPF expectations for longer-term inflation have risen slightly. Since the August survey, the 5-year measure has risen to 2.4 percent from 2.3 percent. During the same period, the 10-year inflation expectation also increased—again, by 0.1 percentage points—to 2.5 percent. These increases since the August survey are bringing these two measures closer to their historical levels.

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