Survey- and Market-Based Inflation Expectations
With the latest CPI release, some indicators of inflation are still at very low levels. The monthly CPI inflation rate rose to 0.2 percent in February after being negative for the previous three months, while the year-over-year CPI inflation rate was 0.0 percent. On the other hand, the core CPI, which excludes volatile energy and food prices, was 1.7 percent year-over-year, a slight increase over its level of 1.6 percent in the previous two months. Still, annual core CPI inflation is about 0.2 percent lower than its level in June 2014. Since expectations are an important factor affecting future inflation and one of the variables attended to closely by the FOMC, this piece looks at recent trends in various measures of inflation expectations.
First we look at three measures of short-term inflation expectations—the median expectation from the monthly University of Michigan Survey of Consumers (UM Survey) and the median CPI and core CPI expectations from the quarterly Philadelphia Fed Survey of Professional Forecasters (SPF).
The 1-year UM inflation expectation declined from 3.3 percent in July 2014 to 2.5 percent in January 2015, its lowest value since September 2010. The declining price of oil seems to be the main culprit here, as earlier episodes of volatile oil prices led to similar changes in this measure. The 1-year inflation expectation from this measure has rebounded since then, with a 3.0 percent reading in the March 2015 survey. The 1-year SPF expectation for core CPI inflation declined 0.3 percent in the last two surveys; it’s now at 1.8 percent. The 1-year SPF expectation for CPI inflation has also declined during this time, with a 1.9 percent level in the last survey.
We now look at the probability measures for the core CPI from the SPF survey. Survey respondents assign probabilities for different ranges of the annual core CPI inflation rate in the fourth quarter of the current year and for the next year. Looking at these probabilities, we see a shift to the left in their distribution at the end of 2015 in the last two surveys. This shift means that the probabilities of the lower ranges increased while the probabilities of the higher ranges declined. Although the 1.5 to 2.0 percent range is still viewed as the most likely outcome at 36 percent, survey participants placed a 37 percent probability on the event that the core CPI will be lower than 1.5 percent at the end of 2015. However, survey participants assign less than a 20 percent probability to the event that the core CPI will be less than 1.5 percent at the end of 2016, with the 1.5 to 2.0 percent range again being the most likely outcome (with a 34 percent probability) and the 2.0 to 2.5 percent range being the second-most likely (with a 30 percent probability).
We conclude that these inflation measures are sending mixed signals. Still, while there have been some declines in the SPF CPI and core CPI short-term inflation expectations, there are no worrying signs of a rapid disinflation. In addition, the two recent UM surveys as well as the probabilities for the core CPI ranges for the next year suggest a relatively higher inflation outlook.
We now turn to long-term inflation expectations. The UM inflation expectation in 5 to 10 years has been hovering around the 2.7-2.8 percent range over the last four months and is at 2.8 percent in March 2015. On the other hand, the SPF expectation for CPI inflation in 5 years eased 0.2 percent in the last two surveys. It’s at 2.0 percent in the 2015:Q1 survey, the lowest since 2010:Q4. The SPF 10-year CPI inflation expectation has been on a declining trend since 2014:Q1 and is at 2.1 percent in the 2015:Q1 survey, its lowest level on record since the SPF survey started to ask for this particular expectation in 1991:Q4. Although the SPF series have not shown significant jumps and the levels are not far from their recent averages, the figures still reveal a declining inflationary pressure in the long-term outlook.
Finally, we look at a few market and model-based expectations of long-term inflation—the 10-year TIPS breakeven inflation rate, the 10-year inflation swap rate, and the 10-year inflation expectation from the Federal Reserve Bank of Cleveland model, which incorporates market and survey data and is able to separate the expectation from an inflation risk premium component, which is likely to contaminate the market-based measures.
Market measures of inflation expectations were on a declining trend between mid-summer 2014 and mid-January 2015. For example, the 10-year inflation swap rate fell by 0.90 percent between July 25, 2014, and January 13, 2015. Although these measures increased until early March, they started to recede again thereafter. As of March 16, the 10-year TIPS breakeven rate is 1.65 percent and the 10-year inflation swap rate is 1.88 percent. The FRBC 10-year inflation expectation measure declined by 0.4 percent between September 2014 and February 2015, to 1.5 percent. In March 2015 it picked up and now is at 1.7 percent.
To conclude, we have seen the recent data point to a decline in the SPF and market-based measures of long-term inflation expectations. In the case of the SPF, the declines were limited, although the 10-year inflation expectation was at its lowest value. In the case of the market-based measures, the declines have been partially reversed since January but still point to a relatively larger ease of long-run inflation pressures. The model-based measure picked up in March but still shows an expectation of only 1.7 percent for the average rate of inflation over the next 10 years.