Long term inflation expectations

What Is Long Term Inflation Expectations?

Long term inflation expectations refer to the average rate of inflation that economic agents, such as consumers, businesses, and investors, anticipate will prevail over an extended period, typically five to ten years or more. This concept is a crucial component within the broader field of monetary policy because these expectations significantly influence actual future inflation rates, wage setting, and investment decisions. When individuals and firms expect higher inflation in the long run, they may demand higher wages or increase prices for goods and services, creating a self-fulfilling prophecy. Conversely, stable long term inflation expectations can help central banks achieve their price stability mandates by anchoring inflationary pressures.

History and Origin

The significance of inflation expectations, particularly long-term ones, gained prominence in economic theory and central banking practice following the high inflation periods of the 1970s. Prior to this, macroeconomic models often overlooked the role of expectations, assuming adaptive behavior where expectations were simply based on past inflation. However, the stagflation of the 1970s, characterized by both high inflation and high unemployment, demonstrated that expectations could become "de-anchored" from central bank targets, leading to persistent inflationary spirals.

In response, modern central banking, spearheaded by institutions like the Federal Reserve and the European Central Bank, placed a greater emphasis on managing and anchoring long term inflation expectations. This shift led to the adoption of inflation targeting regimes by many central banks, aiming to clearly communicate their commitment to maintaining price stability. By transparently setting and pursuing an inflation target, central banks seek to influence public and market expectations, thereby fostering a stable economic environment. The Federal Reserve Bank of Philadelphia, for instance, has conducted its Survey of Professional Forecasters, the oldest quarterly survey of macroeconomic forecasts in the United States, since 1968, providing valuable insights into these expectations¹⁰. Similarly, the European Central Bank's Survey of Professional Forecasters collects information on expected inflation rates over various horizons, including the longer term⁸, ⁹.

Key Takeaways

• Long term inflation expectations represent the anticipated average rate of inflation over an extended future period, typically 5-10 years.
• They are a critical determinant of actual future inflation, as they influence wage and price-setting behavior.
• Central banks actively monitor and strive to anchor these expectations to their inflation targets to maintain price stability.
• De-anchored long term inflation expectations can lead to greater economic instability and challenges for monetary policy.
• Measures include surveys of professional forecasters and market-based indicators derived from bond market instruments.

Formula and Calculation

One widely used market-based measure of long term inflation expectations is the breakeven inflation rate. This rate is derived from the difference in yields between a nominal U.S. Treasury security and a Treasury Inflation-Protected Security (TIPS) of the same maturity.

For example, the 10-Year Breakeven Inflation Rate is calculated as:

$\text{Breakeven Inflation Rate} = \text{Nominal 10-Year Treasury Yield} - \text{10-Year TIPS Yield}$

Where:

• Nominal 10-Year Treasury Yield: The yield to maturity on a standard 10-year U.S. Treasury security.
• 10-Year TIPS Yield: The real yield to maturity on a 10-year Treasury Inflation-Protected Security.

This formula essentially reveals the average annual inflation rate that market participants expect over the life of the bond, such that the total return from the nominal bond would equal the total return from the TIPS. It reflects the compensation investors demand for expected inflation. The Federal Reserve Bank of St. Louis's FRED database provides historical data for the 10-Year Breakeven Inflation Rate⁶, ⁷.

Interpreting Long Term Inflation Expectations

Interpreting long term inflation expectations involves understanding both their level and their stability. A stable level of long term inflation expectations, particularly around a central bank's target (e.g., 2%), is generally seen as a sign of credible monetary policy and a well-anchored inflation environment. When these expectations remain consistent, it indicates that economic agents believe the central bank will successfully achieve its price stability objective over time, regardless of short-term economic fluctuations.

Significant deviations or increased volatility in long term inflation expectations can signal concerns. For instance, a sustained rise above the central bank's target might suggest that markets or forecasters anticipate persistent inflationary pressures, potentially leading to demands for higher interest rates. Conversely, a drop below target could indicate fears of prolonged deflation or weak economic growth. Central banks closely monitor these movements, as de-anchored expectations can make it more challenging to manage inflation and stabilize the economy.

Hypothetical Example

Consider an individual, Sarah, who is planning for her retirement. She is evaluating how much she needs to save to maintain her desired lifestyle. If Sarah expects long term inflation to average 3% per year, she knows that the cost of living will roughly double every 24 years due to the erosion of purchasing power. This anticipation will influence her investment decisions, leading her to seek investments that offer returns potentially higher than 3% to preserve her real wealth.

If, however, a reliable survey of long term inflation expectations indicates a stable average of 2% for the next decade, Sarah might adjust her savings rate or asset allocation accordingly. She would still account for inflation, but perhaps with a slightly less aggressive investment strategy, confident that her savings will retain more of their value over time. This illustrates how even non-professional individuals implicitly or explicitly consider long term inflation expectations when making significant financial plans.

Practical Applications

Long term inflation expectations are indispensable in various facets of finance and economics:

• Monetary Policy Formulation: Central banks like the Federal Reserve and the European Central Bank heavily rely on long term inflation expectations to guide their monetary policy decisions. Stable expectations around their inflation targets signal policy credibility, allowing them more flexibility to respond to short-term economic shocks. Conversely, rising or volatile expectations may prompt central banks to tighten monetary policy more aggressively to re-anchor them. An IMF Working Paper highlights that efforts to improve the anchoring of inflation expectations in emerging markets pay off, easing the trade-off central banks face when external shocks weaken growth prospects and trigger currency depreciations⁴, ⁵.
• Investment Strategy: Investors use long term inflation expectations to gauge the real return on their investments. For instance, bond investors analyze breakeven inflation rates to assess the attractiveness of nominal bonds versus inflation-protected securities. Equity investors consider how anticipated long-term inflation might affect corporate earnings, valuations, and the future purchasing power of dividends.
• Wage and Price Setting: Businesses and labor unions incorporate long term inflation expectations into their negotiations. If employees expect higher long-term inflation, they may demand higher wages, which in turn can feed into higher production costs and consumer prices, perpetuating inflationary cycles.
• Financial Market Analysis: Analysts in financial markets monitor indicators of long term inflation expectations, such as the 10-Year Breakeven Inflation Rate, as a key gauge of market sentiment regarding future price levels³. Movements in these rates can influence asset allocation decisions and risk management strategies.
• Government Fiscal Planning: Governments consider long term inflation expectations when projecting future tax revenues, government spending, and the sustainability of public debt. Inflation can erode the real value of outstanding debt but also increase the cost of future public services.

Limitations and Criticisms

Despite their importance, long term inflation expectations have limitations and face criticisms. One challenge is accurately measuring these expectations, as different methodologies (surveys vs. market-based measures) can yield varying results. Surveys, like the Survey of Professional Forecasters, capture stated beliefs but may not always perfectly reflect real-world actions. Market-based measures, such as breakeven rates, offer real-time insights but can be influenced by factors beyond pure inflation expectations, such as liquidity premiums or risk premium associated with inflation uncertainty².

Furthermore, the concept of "anchoring" itself is complex. While central banks strive for well-anchored expectations, a perfectly rigid anchor might not be desirable, as some flexibility could be needed for necessary relative price adjustments. There's also debate about which economic agents' expectations matter most. While professional forecasters and financial markets are closely watched, the expectations of households and firms, which directly influence consumption and production decisions, can be harder to quantify and may diverge. Some research indicates that professional forecasters might exhibit overconfidence in their long-horizon predictions for inflation¹.

Moreover, in times of significant economic disruption or unprecedented monetary policy actions, long term inflation expectations can become more volatile or "de-anchored," making their interpretation and utility for policy challenging.

Long Term Inflation Expectations vs. Short Term Inflation Expectations

The primary distinction between long term inflation expectations and short term inflation expectations lies in their respective time horizons and the factors that influence them.

While short term inflation expectations react more dynamically to recent inflation data (like the Consumer Price Index (CPI)) and immediate economic news, long term inflation expectations are more insulated from these day-to-day fluctuations. They reflect a more fundamental belief in the central bank's ability to maintain price stability over an extended period. A divergence between the two can signal that short-term pressures are either expected to be transient or that the market is losing faith in the central bank's long-run commitment.

FAQs

What does it mean for inflation expectations to be "anchored"?

When inflation expectations are "anchored," it means that economic agents generally believe that future inflation will remain stable and close to the central bank's stated target over the long run, even in the face of temporary economic shocks or policy changes. This stability helps to prevent self-fulfilling inflationary spirals.

Why are long term inflation expectations important for central banks?

Long term inflation expectations are crucial for central banks because they directly influence actual inflation. If people expect stable prices, they are less likely to demand excessive wage increases or raise prices significantly, making the central bank's job of achieving price stability easier. If these expectations become unanchored, inflation can become much more difficult to control.

How are long term inflation expectations measured?

They are primarily measured in two ways: through surveys of professional forecasters and economists (like the Federal Reserve Bank of Philadelphia's Survey of Professional Forecasters) and through market-based indicators, such as the breakeven inflation rate derived from Treasury securities and Treasury Inflation-Protected Securities (TIPS).

Can long term inflation expectations predict actual inflation?

Long term inflation expectations are not direct predictions of future inflation but rather indicators of what market participants and forecasters expect inflation to be. They are influential in shaping actual inflation, making them a significant factor for policymakers and investors to consider, but they do not guarantee a specific future inflation outcome.