How is Expected Inflation different from Regular Inflation?

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What is expected inflation?

Expected inflation (inflation expectation) is the rate of inflation that people predict will occur in the future.

How important is expected inflation?

People’s expectations about the future significantly influence their current behavior. For instance, if expected inflation for the next year is 3%, businesses anticipate that their input costs will rise by 3%, leading them to increase product prices by 3% to maintain profit margins. Consequently, employees may demand a 3% wage increase to keep up with their purchasing power, driving actual inflation to rise by 3%.

If future inflation expectations are relatively high, consumers tend to spend more in the present because prices are cheaper now than in the future. This increased demand can drive up actual inflation.

So, what does expected inflation mean for consumers and businesses, and how does it affect central banks?

For Central Banks

The primary goal of central banks is to control inflation. Therefore, policymakers monitor expected inflation figures to assess the effectiveness of their policies. For example, if the Fed’s inflation target is 2%, but expected inflation in the US is 1%, it indicates that the public does not believe the Fed’s policies are effective. Moreover, low expected inflation changes the behavior of businesses and consumers, pushing actual inflation closer to 1%, making it harder for the Fed to bring inflation back to the 2% target. Hence, central banks also focus on expected inflation when implementing monetary policies, striving to align actual and expected inflation with their targets.

How is expected inflation measured?

While inflation is measured by price indices such as CPI, PCE, and HICP, there are three methods to measure expected inflation: surveys, economic forecasts, and market-based financial instruments.

Surveys

Organizations conduct surveys asking consumers, investors, and businesses about their future inflation expectations and then average the responses to publish the expected inflation rate. Notable survey organizations in the US include the University of Michigan and the Philadelphia Fed.

Economic Forecasts

Economists use forecasting models based on economic data to calculate and predict future inflation rates.

Market-Based Financial Instruments

The most common method to measure expected inflation is based on market expectations, derived from traded financial assets.

The most widely known indicator for expected inflation is the breakeven inflation rate, which is the difference between the yields on nominal government bonds and inflation-protected government bonds (TIPS) of the same maturity, often the 10-year maturity. For example, if the 10-year Treasury yield is 1.05% and the 10-year TIPS yield is -1.04%, the 10-year expected inflation rate is 1.05% – (-1.04%) = 2.09%.

This calculation is based on a simple premise: when investors fear rising inflation, the demand for TIPS increases, pushing their prices up and their yields down. Assuming nominal bond yields remain unchanged, this causes expected inflation to rise.

Additionally, 5-year and 30-year expected inflation rates are calculated using similar methods.

Recent Focus of the Fed

Recently, the Fed has focused more on measuring expected inflation based on the 5-year forward inflation expectation rate (5y5y breakeven inflation rate). This figure represents the average expected inflation rate from the beginning of the 6th year to the end of the 10th year from the present. The 5y5y expected inflation rate is calculated using the formula below:

(1+A)^5(1+B)^5 = (1+C)^10

where A is the average inflation rate for the first 1-5 years, B is the average inflation rate for years 6-10, and C is the average inflation rate for years 1-10.

This method provides a more accurate measure of market-expected inflation because TIPS are less frequently traded and have lower liquidity compared to nominal Treasury bonds, sometimes leading to yields that do not accurately reflect expectations. Thus, the 5y5y expected inflation rate helps to “filter out noise” in expected inflation calculations.

The Index of Common Inflation Expectations (CIE)

Economists at the Fed have created an Index of Common Inflation Expectations (CIE), calculated as an average of 21 different expected inflation indicators derived using all three methods mentioned above. In a speech on 16/11/2020, Vice Chairman Richard Clarida mentioned using the CIE to assess the effectiveness of the Fed’s monetary policy. The CIE has remained stable around 2% since the 2000s, aligning with the Fed’s target.

How Do Central Banks Influence Expected Inflation?

The simplest way to influence expected inflation is through monetary policy. For example, when the Fed implemented monetary easing in March this year by lowering policy rates and launching an unlimited QE program, it led to an increase in future inflation expectations, as reflected by the rising expected inflation rates since then.