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Short- and Long-Term Inflation Expectations

Consumer prices are rising slowly according to the latest data, although the disinflationary pressure seen in the spring has abated. Annual inflation was 1.5 percent in August 2013 as measured by the CPI and 1.8 percent as measured by the CPI excluding food and energy (usually referred to as the "core CPI"). Underlying inflation measures, such as the median and trimmed-mean CPI, have picked up, and the volatile energy component, coming in at -0.1 percent year-over-year in August, drove CPI inflation lower than core CPI inflation.

Annual Inflation

To gauge where households, professional forecasters, and market participants expect inflation to be in the future, we look at recent survey and market-based measures of inflation expectations. These measures are among the most successful predictors of future inflation.

The two surveys we use are the University of Michigan's Survey of Consumer Attitudes and Behavior (UM survey) and the Philadelphia Fed's Survey of Professional Forecasters (SPF). The UM survey is monthly and the SPF is quarterly. The most recent UM survey was released in September, and the most recent SPF was released in August for the third quarter of 2013. The UM Survey does not specify a particular basket for its questions on inflation expectations, whereas professional forecasters are asked their opinions on the CPI and the core CPI. Note that we report the median responses. The market-based measures we'll look at are the breakeven inflation rates calculated from TIPS and nominal Treasuries and inflation swap rates (find an update on inflation expectations based on the Cleveland Fed's model here).

UM Survey participants expect CPI inflation to be 3.2 percent in one year, as of September 2013. The UM one-year-ahead expectation has been stable throughout 2013, compared to earlier periods. In contrast, SPF participants expect CPI inflation to be 1.86 percent in one year, as of August 2013. The SPF one-year-ahead expectation has declined considerably since the last quarter of 2012; it was 2.19 percent in November 2012. SPF expectations for the core CPI have also been quite stable, ranging between 2.0 percent (February 2013) and 1.96 percent (August 2013).

Survey-Based One-Year-Ahead Inflation Expectations

The SPF also asks respondents to assign probabilities to particular ranges of annual core CPI inflation for the end of the current year and the next year. The numbers in 2013:Q4 show that the distribution has shifted to the left over time, meaning that respondents think that core CPI inflation in 2013:Q4 will be lower than they initially thought. As of 2013:Q3, they assigned about a 50 percent probability on average to the range of 1.5 percent to 2.0 percent. A similar shift to the left is also seen for 2014:Q4 annual core CPI inflation; the 1.5-2.0 percent range is now seen as the most likely, with a probability of 39 percent, whereas the higher 2.0-2.5 percent range was seen as the most likely outcome in the 2013:Q2 survey.

Core CPI Probabilities, 2013:Q4
Core CPI Probabilities, 2014:Q4

The long-term inflation expectation of UM Survey participants hovered around 2.9 percent throughout 2013 and hit 3.0 percent in September. The SPF long-term measures, on the other hand, have been following a declining trend, with 5-year inflation expectations falling 0.2 percentage points in 2013 to 2.1 percent, while the 10-year expectation dropped 0.09 percentage points to 2.21 percent.

Survey-Based Medium and Long-Term Inflation Expectations

Moving to market-based expectations, we see that these measures declined considerably from the beginning of 2013 until the middle of June. For example, the 5-year breakeven inflation rate dropped 50 basis points to 1.62 percent on June 24, 2013, and the 10-year inflation swap rate declined 40 basis points to 2.34 percent. Both measures had picked up to some extent by early August, but they have since dropped back down to levels considerably lower than where they were in the beginning of the year. For example, as of September 17, the 10-year swap rate was 2.16 percent, 32 basis points lower than it was on January 2.

Market-Based Inflation Expectations

Taken together, these measures suggest that investors expect lower inflation in the medium and long term. The short-term expectations measures are mixed; SPF expectations for the CPI one year ahead have signaled a disinflationary outlook, while expectations for other measures, such as SPF 1-year core CPI expectations and UM 1-year inflation expectations, have been more stable.

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