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Expected Inflation Is Trending Higher

Expected inflation has moved up. The latest estimate of the inflation expected in 10 years is 1.86 percent, an increase of 0.10 percent over last month's rate of 1.76 percent. Expectations for inflation have been increasing for the last four months, with the largest increase between May and June of this year (0.15 percent). This four-month trend has pushed expectations to the highest levels we have seen in the past two years, yet at only 1.86 percent, expected inflation remains well below the average rate we have experienced over the last seven years.

Ten-Year Expected Inflation and Inflation Risk Premium

The rate of inflation expected in the future is only one concern people have when it comes to dealing with inflation. Another is that the rate may end up significantly higher or lower than they expect, and the risk premium measures how worried people are about that possibility. Inflation risk premiums can move about for two very different reasons. Inflation may become more variable, so people are more uncertain about where prices will end up, or the stakes of misjudging the future rate could become higher.

The inflation risk premium increased 0.02 percent in September and ended the month at 0.48 percent. The premium has been rising in the last six months, clearly observable in the above graph. The inflation risk premium experienced larger increases in June and July (0.04 and 0.06 percent month-over-month). While September's reading continues the upward trend, there is a noticeable flattening of the inflation risk premium line from July to September.

Looking at the long-term record of inflation expectations, recent values, even with the increases, remain much lower than the levels we have observed over the last 30 years. Expectations gradually declined from early 1982 to about 2003, after which they began to fluctuate in the neighborhood of 2 percent. Since that time, expected inflation has remained low by historical standards.

Ten-Year Expected Inflation and Inflation Risk Premium

For estimates of inflation expectations in a forward-looking time frame, analysts typically turn to TIPS data. However, TIPS data are not ideal for this purpose, because TIPS (Treasury inflation-protected securities) are generally issued with five- and 10-year maturities. The Cleveland Fed model of inflation expectations captures forward expectations from other financial instruments and can give a better idea of what future expectations may be at a greater variety of future time periods. And though the 5-year, 5-year forward rate is a popular measure, a more relevant time frame for monetary policy purposes is between two and five years, for which the three-year, two-year forward rate is used. This rate rose slightly in September (0.08 percent) and is now at 1.7 percent. This increase was slightly higher than August's increase of 0.05 percent.

3-Year, 2-Year-Forward Inflation Rate

Yet another way to look at inflation expectations is with an expected-inflation "yield curve," which plots expectations for different time horizons. This yield curve shifted up between August 2013 and September 2013.

The difference between August and September is evident in the one- to five-year-horizon range, but short-term rates are not considered the most reliable indicator of expectations because they fluctuate from month to month. Long-term rates, on the other hand, are less variable, at least for the past several years.

Looking at the longer-term horizons of these yield curves, we see that expected inflation has been shifting up since last year, with a noticeable shift up from August to September of this year. The yield curve for September 2013 crosses the 2.0 percent threshold around the 19-year horizon. In August, it didn't cross until the 22-year mark. Back in September 2012 the yield curve did not reach 2.0 percent even at a 30-year horizon. Even with the yield curve now crossing 2.0 percent at an earlier date than in previous months, inflation remains well-anchored.

Expected Inflation Yield Curve

Overall the increase in inflation expectations in the last few months has reversed the trend of the low expected rates that we have observed for several years. Yet even with this increase, expected rates remain historically low.

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