What are inflation expectations, and why do they matter?
As appeared in the Cleveland Fed Digest's Ask the Expert
Inflation expectations are what people expect future inflation to be, and they matter because these expectations actually affect people’s behavior. It’s easy to understand how things in the past impact what I do today. Expectations about the future can also impact what I do today. For example, I may not buy a house, I may not invest in a piece of equipment or expand my business, or I might do it all, depending on my expectations.
If people expect inflation to be lower and they act on those beliefs, they could, in fact, cause inflation to be lower. If businesses expect lower inflation, they may raise prices at a slower rate; they don’t want the prices of their items to look too out of line with those of their competitors. If workers expect lower inflation, they may ask for smaller wage increases. The combination of businesses and workers acting in this manner will result in the economy experiencing lower inflation. Firms raise prices at a slower rate but also face lower wage pressures, while workers receive lower wage gains but see prices increasing at a slower pace.
The challenge for policymakers is that even though they know inflation expectations are important, expectations are not something that they can observe directly. They have to rely on measures of expected inflation that are constructed from surveys and economic models.
Businesses and the general public can use what’s known about inflation expectations to adjust their own inflation expectations. If I were expecting 1 percent inflation, and I learned that others were expecting 2 percent, I’d likely revise my expectations to something higher than 1 percent. Because I expect prices to go up faster—higher expected inflation—I might alter my actions and purchase items now before their prices go up.
Policymakers use inflation expectations as a barometer: How closely aligned are people’s expectations with the inflation objective the Federal Reserve wants to achieve?
The Federal Reserve’s inflation objective is 2 percent inflation, as inflation around this level is associated with good economic performance. A higher inflation rate could prevent the public from making accurate longer-term economic and financial decisions, while a lower rate may make it harder to keep the economy from falling into deflation should economic conditions become weak.
So if the public expects inflation to be 1.4 percent, then we now have a worrisome disconnect. Policymakers will take that as a sign that people don’t think the Fed can hit its inflation objective. We might then see the scenario I described above, where lower inflation expectations could set in motion forces to move inflation lower and thereby make it more difficult for the Fed to achieve its 2 percent inflation objective.
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