Individuals make choices based not only on past events and current developments, but also by looking forward and thinking about the future. Moreover, when individuals act on their beliefs, there is the possibility that expectations can lead to self-fulfilling outcomes. That is, if individuals expect a certain event to occur and others share the same view, then their collective behavior can cause the expected event to take place when it otherwise may not have. Consequently, expectations can affect economic outcomes.
Policymakers recognize the forward-looking nature of consumers and firms, and this explains why they not only consider it important to track inflation, but also why they consider it important to measure and monitor inflation expectations—what people think or anticipate inflation will be in the future. This is because people’s inflation expectations play a key role in the economic and financial decisions they make, and thus their inflation expectations will affect, among other things, what actual inflation turns out to be.
For example, the prices that firms set for their products and services will depend in part on what they expect their competitors to charge for their products and services. Because prices do not adjust continuously, they need to be set at the “right” level based on today’s conditions and those expected to hold over some time in the future. Workers, who are concerned about the real purchasing power of their wages—what their paychecks will be able to buy after adjusting for the prices of goods and services—will incorporate inflation expectations into their wage negotiations. And because lenders want to achieve a desired real return from their savings (the rate of return minus the rate of inflation), they will include a component in interest rates to compensate them for the rate they expect inflation to be.
For the conduct of monetary policy, inflation expectations provide policymakers with a basis to assess the credibility of stated inflation objectives as well as the degree that expectations are “anchored”—that is, the extent to which expectations are not affected by incoming data. If inflation were to run higher or lower than the public expected for a period of time but that experience didn’t change the public’s long-run expectation of inflation much, then economists would typically say that inflation expectations are well anchored.
In spite of inflation expectations’ importance, their measurement is problematic because they reflect individuals’ personal beliefs, which are not observed. Two approaches have been developed to address this difficulty—model-based measures of inflation expectations and survey-based measures of inflation expectations. Because there is no consensus about which approach is superior, we discuss both types of measures of expected inflation.
Model-based measures of expected inflation rely on estimation, wherein theory and statistical methods are combined and then applied to data. The data typically include financial variables and inflation series, but other information may be incorporated in accordance with the specified model.
Survey-based measures of expected inflation are derived by directly soliciting the views of respondents about the inflation outlook. There are, however, differences across the surveys that include the types of people who are contacted for the survey, the variables of interest, the forecast horizons, and even how the relevant inflation questions are asked, which can affect the interpretation of the responses. In addition, the surveys are not narrowly focused on inflation and also provide information on individuals’ expectations about the future values of a host of other economic and financial variables.