Inflationary expectations

Inflationary Expectations: Definition, Measurement, and Impact

Inflationary expectations, a core concept in macroeconomics and monetary policy, refer to the rate at which consumers, businesses, and investors anticipate prices will rise in the future. These beliefs about future price levels significantly influence current economic decisions, affecting everything from wage negotiations to investment strategies. They are a critical consideration for central bank policymakers aiming to maintain price stability.

History and Origin

The concept of expectations playing a role in economic outcomes has long been acknowledged, but the formal integration of "rational expectations" into macroeconomic theory gained prominence in the 1960s and 1970s. John F. Muth introduced the concept of rational expectations in 1961, suggesting that individuals make decisions based on the best available information and economic theories, even if they are sometimes wrong on average. Economists Robert Lucas and Thomas Sargent further popularized this theory, challenging the then-dominant Keynesian views.⁵⁰, ⁵¹, ⁵²

The development of the "expectations-augmented Phillips Curve" highlighted how inflation expectations could shift the trade-off between inflation and unemployment.⁴⁸, ⁴⁹ During the "Great Inflation" period of the 1970s, it became evident that public expectations about continuous price increases could become self-fulfilling, leading to persistent inflation.⁴⁷ This era underscored the critical importance of anchoring inflation expectations for effective monetary policy.⁴⁶

Key Takeaways

• Inflationary expectations reflect the anticipated rate of future price increases by economic agents.
• They influence current decisions regarding spending, saving, investing, and wage setting.
• Central banks closely monitor inflation expectations as they are a key determinant of actual inflation.
• Well-anchored inflation expectations are crucial for maintaining price stability and effective monetary policy.
• Various methods, including surveys and market-based indicators like Treasury Inflation-Protected Securities (TIPS), are used to measure these expectations.

Interpreting Inflationary Expectations

Interpreting inflationary expectations involves understanding how different economic agents form their beliefs and how these beliefs are measured. Broadly, expectations can be observed through two main approaches: survey-based measures and market-based measures.⁴⁵

Survey-based measures, such as the University of Michigan's Surveys of Consumers or the Survey of Professional Forecasters, directly ask individuals or experts about their inflation outlook.⁴³, ⁴⁴ These surveys often capture a wide range of views and can reveal the degree of disagreement among respondents.⁴²

Market-based measures, like the breakeven inflation rate derived from the difference between nominal Treasury bond yields and Treasury Inflation-Protected Securities (TIPS) yields, reflect the inflation compensation demanded by investors.³⁹, ⁴⁰, ⁴¹ The yield curve can also offer insights into future inflation expectations across different time horizons.³⁸

Policymakers look for "well-anchored" inflation expectations, meaning that long-term expectations remain stable and close to the central bank's target, typically around 2%, even in the face of temporary price fluctuations.³⁵, ³⁶, ³⁷ If expectations become "de-anchored" and rise significantly, it suggests a loss of confidence in the central bank's ability to control inflation, potentially leading to a self-reinforcing inflationary spiral.³⁴ Conversely, persistently low or falling expectations can signal concerns about deflation or disinflation.

Hypothetical Example

Consider a scenario where the annual Consumer Price Index (CPI) has recently shown an increase of 4%. While the actual inflation rate for the past year was 4%, businesses and consumers might form different inflationary expectations for the coming year.

• Scenario 1: Well-anchored expectations. A major manufacturer, despite seeing input costs rise by 4%, expects future inflation to return to the central bank's 2% target. Based on this expectation, they might implement price increases of only 2.5% to avoid losing market share, believing that higher inflation is temporary. Consumers, also expecting inflation to cool, might not rush to make large purchases, preserving their purchasing power.
• Scenario 2: De-anchored expectations. The same manufacturer, having experienced 4% inflation and observing rising global commodity prices, anticipates future inflation will be 5% or even higher. They might raise their product prices by 4% or 5% to protect their profit margins. Similarly, workers, expecting higher costs of living, might demand wage increases of 5-6%. This widespread belief in higher future prices can lead to a cycle where higher expected inflation translates into higher actual inflation. This self-fulfilling prophecy demonstrates the power of inflationary expectations.

Practical Applications

Inflationary expectations are integral to various aspects of the financial world and policy-making:

• Monetary Policy: Central banks, such as the U.S. Federal Reserve and the European Central Bank (ECB), meticulously track inflationary expectations. They use these insights to guide interest rates and other tools of monetary policy, like quantitative easing, aiming to anchor expectations around their target (e.g., the Fed's 2% target).³¹, ³², ³³ Stable and predictable inflation expectations enable the central bank to manage the economy more effectively.³⁰
• Investment Decisions: Investors factor inflationary expectations into their decisions. For instance, bond investors demand a higher nominal yield if they anticipate higher inflation, to ensure positive real returns.²⁹ Products like Treasury Inflation-Protected Securities (TIPS) are designed to protect against inflation, making their yields a direct market-based measure of expectations.
• Wage Bargaining: Labor unions and employees often incorporate their expectations of future inflation into wage demands during collective bargaining. If workers anticipate higher inflation, they will seek larger nominal returns on their wages to maintain their purchasing power.
• Business Pricing Strategies: Companies consider expected inflation when setting prices for their goods and services. If they expect raw material costs or labor expenses to rise, they may proactively increase prices to preserve profit margins, contributing to actual inflation.
• Fiscal Policy and Government Budgeting: Governments must account for inflation expectations in their long-term fiscal policy planning, including revenue projections and spending on indexed programs.
• Economic Analysis: Economists use various economic indicators and models to forecast inflation expectations, which are then used to predict future economic conditions and inform policy recommendations.²¹, ²², ²³, ²⁴, ²⁵, ²⁶, ²⁷, ²⁸

Limitations and Criticisms

Despite their importance, measuring and interpreting inflationary expectations comes with limitations and criticisms:

• Measurement Challenges: Inflationary expectations are inherently subjective and difficult to quantify precisely.¹⁸, ¹⁹, ²⁰ There are many different measures (surveys of consumers, businesses, forecasters; market-based measures from bonds), and they often yield different results and interpretations, leading to debates among economists.¹⁶, ¹⁷ The Federal Reserve Bank of Cleveland, for instance, develops various indicators, acknowledging the complexity.¹³, ¹⁴, ¹⁵
• Rationality vs. Behavioral Aspects: While economic theory often assumes "rational expectations" where agents use all available information efficiently, real-world behavior may deviate.¹² People's personal experiences, recent price changes (e.g., gasoline prices), and cognitive biases can significantly influence their expectations, sometimes leading to "sticky" or "staggered" information processing rather than fully rational updates.⁸, ⁹, ¹⁰, ¹¹
• Heterogeneity of Expectations: Different groups within the economy (e.g., households, firms, financial markets) may hold vastly different inflation expectations due to varying information sets, processing abilities, or personal economic circumstances.⁴, ⁵, ⁶, ⁷ Focusing on a single aggregate measure might overlook crucial dynamics.
• Causality Debate: While it is widely believed that inflation expectations influence actual inflation, the precise causal link is a subject of ongoing academic debate. Some argue that the relationship is not always straightforward or as strong as commonly assumed in theoretical models.², ³

Inflationary Expectations vs. Actual Inflation

It is important to distinguish between inflationary expectations and actual inflation (also known as realized inflation).

While distinct, the two are closely intertwined. Inflationary expectations can significantly influence actual inflation, as businesses set prices and workers demand wages based on what they expect future inflation to be. Conversely, persistent actual inflation can cause inflationary expectations to rise and become embedded in economic behavior. Central banks strive to keep long-term inflationary expectations aligned with their target to prevent past inflation from dictating future price trends.

FAQs

What causes inflationary expectations to change?

Inflationary expectations can change due to various factors, including current inflation rates, monetary policy announcements, government fiscal policy changes, commodity price shocks (like oil), global economic events, and even media narratives about the economy. Credible actions by the central bank to combat inflation are crucial in anchoring expectations.

How do central banks influence inflationary expectations?

Central banks primarily influence inflationary expectations through their communication and actions. By clearly stating an inflation target (e.g., 2%), adjusting interest rates, and using other tools like quantitative easing or tightening, they aim to signal their commitment to price stability. The credibility of the central bank's commitment is key to effectively managing expectations.

Why are stable inflationary expectations important?

Stable, or "well-anchored," inflationary expectations are vital because they reduce economic uncertainty. When businesses and consumers expect prices to remain predictable, they can make sound long-term decisions regarding investment, saving, and spending. This stability supports sustainable economic growth and helps prevent a wage-price spiral, where rising wages chase rising prices.

Are higher inflationary expectations always bad?

Not necessarily. While excessively high or volatile inflationary expectations are detrimental, a moderate level of expected inflation (e.g., around 2%) is often considered healthy for an economy. A small positive inflation target provides a buffer against deflation, gives the central bank more room to cut interest rates during downturns, and encourages consumption and investment rather than hoarding.

How do economists measure inflationary expectations?

Economists use both survey-based and market-based measures. Survey-based methods involve polling consumers (e.g., University of Michigan survey), businesses, or professional forecasters about their inflation outlook. Market-based measures derive expectations from financial instruments, such as the difference in yields between nominal bonds and Treasury Inflation-Protected Securities (TIPS), which account for expected inflation.