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Long-term Inflation Expectations

In February, the CPI stood at 2.0 percent year-over-year, and the core CPI, which is simply the headline CPI measure excluding food and energy prices, was also 2.0 percent over the same period. How can we predict what inflation will be in the more distant future, especially in light of the Fed's accommodative policies?

We look at several measures of inflation expectations to gauge where economic agents think inflation will go in the future. We report three measures, the first two being inputs in the third: market-based estimates, survey results, and estimates of the Cleveland Fed's model of inflation expectations. Further, we focus on longer-term measures (that is, measures of inflation five years in the future and beyond), because, being more immune than shorter-term measures to short-lived shocks, their paths are truer to more persistent drivers of inflation.

Market-based measures reflect the inflation expectations of investors. These measures rose in the days after September 13, 2012, when the Federal Reserve announced a third round of large-scale asset purchases and decided to keep the target range for the federal funds rate at an exceptionally low level at least through mid-2015. This round of asset purchases, unlike its predecessors, was open-ended, meaning it would continue until the outlook for the labor market improved substantially.

Market-Based Inflation Expectations

Between then and now, longer-term inflation expectations rose moderately and then tapered off slightly. As of March 2013, investors expected inflation to average about 2.4 percent over the next five years and 2.6 percent over the next 10 years. These numbers suggests that investors are not expecting the new Fed policy to boost inflation too far beyond the Fed's target over longer time horizons.

Two well-known surveys of inflation expectations reflect the views of consumers and professional forecasters. The University of Michigan's Survey of Consumer Attitudes and Behavior (UM Survey) reports its findings monthly, and the Philadelphia Fed's Survey of Professional Forecasters (SPF) is quarterly.

Survey Measures of Inflation Expectations

Both UM Survey (5- to 10-year) and SPF (5-year and 10-year) expectations were rather stable over 2012. The former hovered between 2.7 percent and 3 percent, ended the year at 2.9 percent, and have stood at 3 percent for the past two months. The 5-year SPF expectation fluctuated between 2.2 percent and 2.3 percent and ended the year at 2.28 percent. Ten-year SPF expectations stayed between 2.3 percent and 2.48 percent. Interestingly, SPF measures for both horizons currently stand at about 2.3 percent.

Estimates from the Cleveland Fed's model of inflation expectations paint a similar picture. Throughout 2012 and so far in 2013, longer-term measures from the model have remained quite stable, hovering comfortably between 1 percent and 2 percent.

Federal Reserve Bank of Cleveland's Model-Based Inflation Expectations

Of course, we cannot associate all the swings in the measures with the Fed's policy announcements. Like any other macroeconomic variable, expectations are affected by other variables and beliefs about future economic conditions. It is very hard to disentangle the effects of such assessments from announcements of policy changes. However, looking at the data, it seems that agents do not see an inflationary threat on the horizon.

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