Modern theories posit that actual inflation depends importantly on expected inflation. But how accurate are measures of expected inflation? A recent Economic Synopses essay examined the accuracy of measures of long-term inflation expectations.
Business Economist and Research Officer Kevin Kliesen noted that the current Monetary Policy Report to the Congress indicates that policymakers regularly examine several measures of inflation expectations, such as:
In his essay, Kliesen looked at a survey-based measure of expected inflation and a market-based measure:
These measures were compared to the compounded annual rate of growth in the CPI for the period five to 7.5 years later, as this horizon is assumed to be a reasonable approximation of the midpoint of the five- to 10-year horizon for the two measures of inflation expectations. For example, in January 2003, the survey-based measure reported an average expected inflation rate of 2.7 percent over the subsequent five to 10 years, while the market-based measure indicated inflation expectations of 2.1 percent. The compounded annual rate of growth in the CPI for the period January 2008 to July 2010 was around 1 percent, showing that actual inflation was much less than expected.
Kliesen found that households routinely overestimated inflation and also assumed higher expected inflation than financial markets did for the entire period studied. The mean of the survey-based measure was 49 basis points higher than the market-based measure and more than 100 basis points higher than the actual rate of inflation.
Kliesen also showed the root mean squared error (a commonly used statistic to gauge the accuracy of forecasts) for each measure of inflation expectations. He found that the market-based measure was 34 percent more accurate than the survey-based measure.
He wrote, “When using measures of inflation expectations to forecast future inflation, policymakers and forecasters should focus on market-based measures of inflation expectations. They are much more accurate than survey-based measures.”
1 Kliesen’s analysis was limited to a period beginning in January 2003, because a consistent measure of inflation-indexed Treasury securities (constant maturity) has been around only since January 2003. He used the five-year, five-year forward breakeven inflation rate, which measures the market’s CPI inflation expectations for the five-year period beginning five years from now.