Recent Developments in Prices and Inflation Expectations
During the recent recession, the FOMC decreased the federal funds rates to a range between zero and 25 basis points. In addition, unconventional policy tools were used to provide further stimulus. As the economy recovers, there has been much interest about the strategy of exiting from this accommodative policy. Since the Fed conducts monetary policy to achieve its dual mandate of maximum sustainable employment and price stability, the exit strategy will depend on the developments in prices as well as the real economy. A look at recent developments in CPI and PPI inflation suggests we are in a period of disinflation (that is, prices are increasing at a slower rate than they were before). Short- and long-term inflation expectations reveal no significant threat of inflation is anticipated.
Headline CPI started to decline in the second half of 2008. Year-over-year CPI inflation stayed negative during most of 2009, mostly due to sharp monthly declines in the last quarter of 2008. The year-over-year rate picked up in early 2010 and was around 2 percent as of May 2010. The headline CPI measure includes volatile items such as food and energy prices, over which monetary policy has limited effect. For example, the monthly declines in the headline CPI during late 2008 arose in part from the sharp decline in energy prices.
For this reason, the Fed also pays attention to what economists call “core price indices,” which try to limit the effects of volatile items like food and energy on the indicators. Two such measures have been developed here at the Cleveland Fed (for further information about these measures, this page.). These measures, the trimmed-mean CPI and median CPI, as well as the CPI excluding food and energy prices, show that there has been a significant disinflation since the second half of 2008. The year-over-year inflation rates for all three measures are at or below 1 percent. Moreover, the recent trend as seen from the three-month changes of those indices also indicates a very disinflationary picture. That annualized rate is 0.1 percent for the median CPI, 0.3 percent for the trimmed-mean CPI and 0.8 percent for the CPI excluding food and energy.
There also seems to be a lack of inflationary pressure on producer prices. The year-over-year inflation rate for the PPI excluding food and energy prices has declined rapidly since late 2008 and hovered around 1 percent so far in 2010. Although there has been an increase in the PPI in the last two months, it still represents no significant inflationary threat. In sum, what we have seen in recent price developments can be labeled as a significant disinflation.
What about inflation expectations? Since people evaluate future general price levels when they set their own prices, inflation expectations not only reflect their perceptions about the future but also influence future inflation. Both survey-based inflation expectations and market-price-based measures give us a measure of these expectations. One commonly used survey-based measure comes from the Survey of Professional Forecasters (SPF), which is conducted quarterly by the Federal Reserve Bank of Philadelphia. We produce monthly figures for SPF inflation expectations by interpolating the quarterly figures. We report several market-price based measures. One is inflation swap rates. In an inflation swap, one counterparty exchanges a variable inflation rate for a fixed inflation rate, the swap rate, with another counterparty. For longer-term expectations we use the breakeven inflation rate, which is the spread between the yield of nominal Treasury and that of a TIPS security of the same maturity. We also use a model-based inflation expectation measure, which also utilizes the information in the term structure of nominal Treasuries in a coherent manner (for further information about these measures, read the Economic Commentary).
Short-term inflation expectations declined rapidly in the second half of 2008. For example, the two-year inflation swap rate became negative in November 2008 and stayed below zero until March 2009. This is most probably related to the liquidity premium, as market agents might use inflation swaps as a hedge for their TIPS-related investment strategies. TIPS breakeven rates also became negative in this period. Nevertheless, survey-based measures such as SPF 1-year inflation expectation also declined significantly during this period. Since mid-2009, short-term inflation expectations bounced back from the very low levels. However, they still stay below two percent and signal little, if any danger for the near-term inflation.
Survey-based long-term inflation expectations seem to be much more stable than the other measures during the last few years. The market-price-based expectations, especially the breakeven inflation rate computed from TIPS and nominal Treasuries, and to some extent swap rates, experienced a significant decline shortly after the Lehman collapse. Parallel to the short-term expectation but to a lesser degree, they have bounced back since mid 2009. In recent months, these measures have hovered around 2.5 percent except for the Cleveland Fed measure, which is currently around 2 percent.
Overall, recent price movements indicate a period of disinflation, while both short-term and long-term inflation expectations point to no significant threat of rising inflation.