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Short- and Long-Term Inflation Expectations

Following three months of flat year-over-year inflation readings as measured by the Consumer Price Index (CPI), November’s reading moved down to 1.3 percent. The core CPI, which had been 1.8 percent in October, ticked down slightly in November, to 1.7 percent. Other measures of underlying inflation, the trimmed-mean CPI and the median CPI, have also been relatively stable since August of this year. 

Figure 1: Measures of CPI Inflation

Declines in the energy component of the CPI help explain the difference between the year-over-year changes in headline and core CPI.  The CPI’s energy component has been declining for the last five months; November’s month-over-month reading is down 3.8 percent, and this was the main driver of the 0.3 percent month-over-month decline in the CPI in November. 

Figure 2: CPI Energy Component

How has the declining trend in CPI inflation over the last few months affected the inflation expectations of households and forecasters? Measures of short-term inflation expectations are mixed. The University of Michigan’s Survey (UM Survey) measure has been declining since July, though it increased slightly in December. The Cleveland Fed one-year inflation expectation has also been declining, but unlike the UM measure, it continued to fall in December. The Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters (SPF) CPI expectation also declined in the fourth quarter. 

UM Survey respondents said in December that they expect inflation in 12 months to be 2.9 percent, which is up from the previous reading of 2.8 percent, the lowest year-ahead inflation rate expected from the UM survey respondents since October 2010. The Cleveland Fed’s model of inflation expectations, which uses survey information from Blue Chip forecasters and the SPF and inflation swap data to calculate inflation expectations, estimates that expected inflation will be below 1.2 percent in the coming 12 months. The SPF one-year CPI inflation expectation in the fourth quarter of 2014 is for 1.9 percent inflation, slightly below the SPF average of 2.0 percent that we have seen over the last year. 

Figure 3: One-Year-Ahead Inflation Expectations

Additional detail from the SPF provides information on how participants in this survey broadly see the risk to inflation in the near term. The SPF asks respondents to assign probabilities to particular ranges of expected year-over-year core CPI inflation for the fourth quarter of the current year and one year ahead. A high probability in one or two particular ranges suggests a bit more certainty for the inflation outlook, while a more balanced set of probabilities on the various ranges suggests less certainty.

The majority of surveyed respondents predict that trailing year-over-year core CPI inflation will be within the range of 1.5 to 2.5 percent as of the fourth quarter of 2014. Respondents’ certainty that core CPI will remain in the lower half of this range, 1.5 to 2.0 percent, has increased, which is probably due to the fact that more data has been released. This suggests that forecasters see the rest of the year’s core CPI numbers to be similar to October’s reading of 1.8 percent.

Figure 4: Core CPI Probabilities, 2014: Q4

Predicted values for the fourth quarter of 2015 are much less certain, with probabilities relatively spread out. Between the third and fourth quarters of 2014, predictions shifted slightly down. As of November, the 1.5-2.0, range is the most likely outcome for 2015:Q4 annual core CPI, replacing the 2.0-2.5 percent range.

Figure 5: Core CPI Probabilities, 2015: Q4

Expected inflation over the longer term (5 to 10 years) looks much more stable than the 1-year-ahead forecast.
In November, UM survey expectations for inflation over the next 5 to 10 years fell to 2.6%, their lowest level since March 2009. But by December, they rebounded to 2.9%, approximately equal to their average rate from the last three years. SPF ten-year expectations are stable, while expected inflation in five years decreased in the fourth quarter from 2.2 percent to 2.1 percent. The FRBC model’s estimate of 10-year expected inflation decreased slightly from November, with a decrease of 0.04 percent to finish at 1.78 percent. 

Figure 6: Core CPI Probabilities, 2015: Q4

Market-based measures of inflation expectations give a general sense of how investors view prospects for future inflation. Two such measures are break-even inflation rates and inflation swap rates. Market-based measures of inflation expectations are experiencing a much sharper decline than survey-based measures. The downward trend began at the end of July and has continued through December. In the first half of 2014, the 10-year breakeven rate was in the range of 2.1 percent to 2.3 percent. In the last two months it has remained below 2.0 percent. The 10-year swap rate for the first half of the year was in the range of 2.4 percent to 2.7 percent. In the last three months, it has been well below this range and continues to fall. As of December 17, 2014, the 10-year breakeven rate was at 1.7 percent and the 10-year inflation swap rate was at 2.0 percent. 

Figure 7: Market-Based Measures of Inflation Expectations

Survey-based measures of inflation expectations seem to remain anchored in the long term, though they show some volatility in the short term. Measures based on financial data, on the other hand, point to long-term expectations for inflation falling below the average range we have seen over the last year. Expectations for long-term inflation based on financial data are, in fact, well below those based on surveyed projections. Assessing whether long-term inflation expectations are anchored depends on which type of measure you consider more reliable: financial measures or survey-based measures.

The views expressed in this article are solely those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Cleveland, the Federal Reserve System, or any of its staff.

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