Inflation expectation

What Is Inflation Expectation?

Inflation expectation refers to the rate at which consumers, businesses, and investors anticipate prices will rise in the future. It is a crucial concept within macroeconomics because these expectations can significantly influence actual price levels and broader economic activity. When individuals and firms expect higher inflation, they often adjust their behavior, which can contribute to the very price increases they anticipate. Inflation expectation is a key consideration for central banks in formulating monetary policy.

History and Origin

The concept of inflation expectation gained prominence in economic theory, particularly with the work of economists like Milton Friedman and Edmund Phelps in the mid-20th century. They highlighted how expectations about future prices are not merely passive forecasts but active determinants of economic outcomes, especially concerning the relationship between inflation and unemployment. Central banks, recognizing the impact of these expectations on overall price stability, began to systematically measure and monitor them. One notable development in this regard is the establishment of various surveys designed to gauge public and professional sentiment. For instance, the Federal Reserve Bank of New York launched its Survey of Consumer Expectations (SCE) in 2013 to better understand household expectations for inflation, labor markets, and household finance.¹⁰,⁹

Key Takeaways

• Inflation expectation represents the anticipated rate of price increases by economic agents.
• These expectations are critical drivers of actual inflation, influencing wage demands and pricing decisions.
• Central banks closely monitor inflation expectations to guide interest rates and monetary policy.
• Measures of inflation expectation are derived from surveys of consumers, businesses, and professional forecasters, as well as from financial markets.
• Well-anchored inflation expectations, consistent with a central bank's price stability goals, are vital for predictable economic growth.

Formula and Calculation

Inflation expectation is not typically calculated using a simple algebraic formula but rather measured through various methods, predominantly surveys and market-based indicators.

• Survey-Based Measures: These directly poll individuals, businesses, or professional forecasters about their expected rate of inflation over various horizons (e.g., one-year, three-year, five-year, ten-year). Prominent examples include:

  • The Survey of Consumer Expectations (SCE) from the Federal Reserve Bank of New York.⁸
  • The University of Michigan's Surveys of Consumers, which includes questions on year-ahead and long-term inflation expectations.⁷
  • The Survey of Professional Forecasters (SPF) conducted by the Federal Reserve Bank of Philadelphia.⁶
  • The Cleveland Fed's Inflation Expectations, which estimates inflation expectations across various time horizons.⁵

• Market-Based Measures: These are derived from financial instruments that embed inflation expectations. A primary example is the "breakeven inflation rate" calculated from the difference in yields between nominal U.S. Treasury securities and Treasury Inflation-Protected Securities (TIPS) of comparable maturity.

  The breakeven inflation rate (BEIR) is expressed as:

  $$\text{BEIR} = \text{Nominal Treasury Yield} - \text{TIPS Yield}$$

  Where:

  • Nominal Treasury Yield = Yield of a conventional Treasury bond with a specific maturity.
  • TIPS Yield = Yield of a Treasury Inflation-Protected Security with the same maturity.

  This formula reflects the market's expectation of average annual inflation over the life of the bond, plus an inflation risk premium. The yield on a TIPS bond provides a measure of the real interest rate, while the nominal Treasury yield incorporates both the real rate and expected inflation.

Interpreting the Inflation Expectation

Interpreting inflation expectation involves understanding its source and the implications for various economic actors. If consumers expect prices to rise significantly, they may accelerate purchases to beat future price increases, which can boost current demand but also contribute to inflationary pressures. Businesses anticipating higher costs might raise their prices proactively to maintain profit margins. In financial markets, a rise in breakeven inflation rates suggests investors foresee higher future inflation, which can impact bond yields and investment strategies.⁴

For policymakers, stable and well-anchored inflation expectations around their target (e.g., 2% for many major central banks) are crucial. If expectations become "unanchored" and rise significantly above target, it signals a loss of confidence in the central bank's ability to control prices, making it harder to achieve price stability. Conversely, expectations that consistently fall below target could signal concerns about deflation or weak demand, prompting different policy responses.

Hypothetical Example

Consider a scenario where a household is planning a major purchase, such as a car, and they observe various measures of inflation expectation.

Sarah and Tom are considering buying a new car. They currently see the average car price at $30,000. Through news reports and economic data, they learn that the one-year inflation expectation is currently 4%. This means that, on average, economists and consumers expect prices to rise by 4% over the next 12 months.

Based on this 4% inflation expectation, Sarah and Tom anticipate the same car model will cost:

If they wait a year, they project the car will cost $31,200. This expectation might influence their purchasing power and lead them to decide to buy the car sooner rather than later to avoid the higher future price. This immediate demand, when aggregated across many consumers, can contribute to actual price increases.

Practical Applications

Inflation expectation has numerous practical applications across finance and economics:

• Monetary Policy Formulation: Central banks like the U.S. Federal Reserve heavily monitor inflation expectations as a gauge of the credibility of their price stability targets. If expectations drift away from the target, it might signal the need for policy adjustments. For example, if long-term expectations begin to rise, the central bank might consider raising its benchmark interest rate to curb potential inflationary pressures. The Federal Reserve Bank of Cleveland, for instance, provides detailed inflation expectation data derived from various indicators, which serves as a vital input for economic analysis.³
• Investment Decisions: Investors use inflation expectations to guide their investment decisions. For instance, if higher inflation is expected, investors might favor real assets like real estate or commodities over fixed-income securities, as inflation erodes the real value of future bond payments. Analysis of the bond market, especially comparing nominal bonds with TIPS, offers direct insights into market-implied inflation expectations.
• Wage Negotiations: Unions and employees often incorporate their inflation expectations into wage demands during collective bargaining. If they expect higher cost of living increases due to inflation, they will seek higher nominal wages to maintain their real wage and purchasing power.
• Business Planning: Businesses consider inflation expectations when setting prices, planning production, and making capital expenditure decisions. Anticipating rising input costs due to inflation may lead firms to raise their output prices, impacting consumer spending.
• Fiscal Policy: Governments consider inflation expectations when formulating fiscal policy, such as indexing benefits (like Social Security) to inflation or issuing inflation-linked bonds.

Limitations and Criticisms

While inflation expectation is a powerful concept, it faces several limitations and criticisms:

• Measurement Challenges: Accurately measuring inflation expectation can be difficult. Survey-based measures can be subjective, influenced by current events, and vary widely depending on the respondent group (e.g., consumers vs. professional forecasters). For instance, while the University of Michigan's Surveys of Consumers provides valuable insights into consumer sentiment, these can sometimes be more volatile than other measures.² Market-based measures, like breakeven rates, can be distorted by liquidity issues or technical factors in the bond market, and they also include an inflation risk premium, which is not purely an expectation of inflation.
• Behavioral Biases: Human psychology plays a significant role in expectation formation. Individuals may exhibit behavioral biases, such as anchoring to recent inflation figures or disproportionately reacting to highly publicized price changes, even if those changes are temporary. This can lead to expectations that deviate from rational forecasts based on economic fundamentals.
• Heterogeneity of Expectations: There is no single, unified inflation expectation. Different groups of people and businesses have varying experiences and information, leading to diverse expectations. For example, small business owners might have different expectations than large corporations or financial analysts.
• "Anchoring" Difficulty: Central banks aim to "anchor" long-term inflation expectations at their target. However, periods of high or volatile inflation can cause expectations to become "unanchored," making it harder for monetary policy to influence actual inflation. The European Central Bank, for instance, extensively researches how to keep long-term inflation expectations stable despite short-term price fluctuations.¹

Inflation Expectation vs. Actual Inflation

While closely related, inflation expectation and actual inflation (also known as realized inflation) are distinct concepts.

The relationship between the two is dynamic. High inflation expectations can become a self-fulfilling prophecy, leading to higher actual inflation. Conversely, effective monetary policy that convinces the public of the central bank's commitment to price stability can help keep inflation expectations anchored, thereby contributing to lower and more stable actual inflation.

FAQs

What causes inflation expectations to change?

Inflation expectations can change due to various factors, including recent Consumer Price Index (CPI) reports, changes in government fiscal policy, shifts in global commodity prices (like oil), or public statements and actions by the central bank regarding its monetary policy stance. Economic shocks, such as supply chain disruptions or geopolitical events, can also significantly influence expectations.

Why do central banks care so much about inflation expectations?

Central banks care deeply about inflation expectations because they are a key determinant of future inflation. If the public expects high inflation, workers demand higher wages, and businesses raise prices, creating a cycle that makes inflation difficult to control. Anchored expectations around the central bank's target help ensure that temporary price shocks do not lead to persistent inflation.

How are inflation expectations measured in the U.S.?

In the U.S., inflation expectations are primarily measured in two ways: through surveys and market-based indicators. Survey data comes from sources like the New York Federal Reserve's Survey of Consumer Expectations, the University of Michigan's Surveys of Consumers, and the Federal Reserve Bank of Philadelphia's Survey of Professional Forecasters. Market-based measures are derived from financial instruments, most notably the breakeven inflation rate calculated from the difference between nominal Treasury yields and TIPS yields.

Can inflation expectations predict future inflation perfectly?

No, inflation expectations are not perfect predictors of future inflation. While they offer valuable insights into anticipated price movements, actual inflation can deviate due to unforeseen economic events, policy changes, or shifts in supply and demand. However, they are still considered a crucial input for economic forecasting and policy decisions.