Why Inflation Expectations Are Important to Policymakers

When people make economic decisions, they consider multiple factors. One might be what they expect inflation to be over some period of time.

“Inflation expectations are very important because they capture the forward-looking behavior of businesses, households, market participants—all of whom make economic decisions every day,” St. Louis Fed President Alberto Musalem said at a Sept. 3 event.

I spoke with Fernando Martin, a senior economic policy advisor in the St. Louis Fed Research Division, for insights into:

• How inflation expectations are measured
• Some advantages and disadvantages of the various types of measures
• Why inflation expectations are important to monetary policymakers
• What can happen if inflation expectations become “unanchored”

Ways to Measure Inflation Expectations

While there is no official measurement of inflation expectations, Martin said there are two fundamental ways to estimate them: through surveys and in financial markets.

Survey-Based Measures of Inflation Expectations

With surveys, people are asked what they think inflation will be, say, one year, five years or 10 years from now, he explained.

• Some surveys, such as the University of Michigan’s Surveys of Consumers, focus on households’ expectations.
• Other surveys, such as the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters, focus on the expectations of professionals, or people whose business is to predict economic indicators.

Market-Based Measures of Inflation Expectations

Market-based measures of inflation expectations provide a good gauge of what people who “put money on the table” think inflation will be over some period of time, Martin said.

For example, people can purchase Treasury inflation-protected securities (TIPS) and standard Treasury securities. (As the name indicates, TIPS are set up to protect buyers against inflation.) Comparing the yields on those two types of securities can give you a rough estimate of what the market expects inflation as measured by the consumer price index (CPI) to be over the period of the bond, Martin said.

How so? The credit risk of the securities is the same because they have the same debtor—the U.S. government. Therefore, the difference in returns can largely be attributed to expected inflation, he explained, although there are other factors.

The graph below from online database FRED shows the five-year breakeven inflation rate, which is an estimate of what market participants think CPI inflation will be in the next five years, on average. The breakeven inflation rate is the inflation rate that would make buying a standard Treasury security as attractive as buying a Treasury inflation-protected security of the same maturity, Martin explained.

Inflation expectations based on the Treasury market are the most common measure of market-based inflation expectations, but the market for inflation swaps can provide another measure. Martin noted that it isn’t a perfect measure either, but it can give a good estimate of expected inflation. (An inflation swap is a financial contract in which one party agrees to pay a fixed amount in exchange for receiving a CPI inflation-adjusted payment by the other party after a certain period of time, as explained in a June 23, 2022, On the Economy blog post.)

Inflation Expectations Measures Compared

Household and Professional Forecaster Survey Measures

“For the survey measures, the big advantage is you’re asking people directly what you want to know,” Martin said.

The disadvantage is that the people answering aren’t investing specifically based on the expectations reflected in their answers. “There’s no stake,” Martin said. “So, if I ask you, you can say whatever you want.”

Martin also cautioned that households’ responses to the inflation question may reflect views based on their own spending habits rather than an average across many categories. For instance, a typical household’s response might reflect prices that don’t have much weight in a market basket of goods and services used for gauging inflation. The difference in perceptions because of buying habits may contribute to a wide range of survey responses.

Professional forecasters may take the question of where they expect inflation to be more seriously than a typical household, Martin said. But they’re also a relatively small group whose thoughts on inflation may not reflect those of the general population. Members of the general population are “the people making decisions all the time about their consumption, mortgages, etc.,” he explained.

Market-Based Inflation Expectations Measures

The advantage of market-based measures is that they’re derived from investment activity—people are putting money on the line, Martin explained.

“The disadvantage is you have to make certain assumptions about how efficient those markets are to really extract the proper information,” he said.

For example, he noted the TIPS market isn’t as liquid or large as the regular Treasury market, which is an additional factor (beyond expected inflation) that may affect the price of TIPS and therefore the estimate of inflation expectations.

Why Inflation Expectations Matter to Monetary Policymakers

People’s expectations of future inflation will fundamentally affect their decisions, Martin said, noting that people contract in nominal terms (that is, without adjusting for inflation) but care about inflation’s effects. When you write a contract, take out a mortgage or agree on a salary, you want to have an estimate of the future value of that money. For instance, is a 7% rate on your mortgage high or low? Is a 2% raise from your employer a lot or a little? The answers would depend in part on what you expect inflation to be, he explained.

Policymakers need to take these expectations into account, Martin said, because people’s decisions will be different if they think inflation will be 2% than if they think it will be 4% or 10%, meaning the impact of policy will be different under those scenarios.

Inflation expectations matter to monetary policymakers because they reflect views of their credibility, Martin said. The Federal Reserve has an inflation target of 2%, based on the annual change in the price index for personal consumption expenditures. If someone says they expect inflation to be 2% 10 years from now, that suggests they trust the Fed to accomplish a rate of around 2% in that time, he explained. But a response of, say, 10% or even 3% or 4% would suggest they don’t trust the Fed will meet its target over that period.

Risks If Inflation Expectations Become Unanchored

Having inflation expectations closer to the Fed’s target (or “anchored”) may mean policymakers wouldn’t have to move the policy rate, or federal funds rate, as much to achieve a particular outcome, Martin said.

But what if inflation expectations become unanchored—that is, what if they move away from 2%?

Unanchored inflation expectations would suggest policymakers are starting to lose credibility, which means they would have to work harder to achieve their goals, Martin said.

He cited as an example the early 1980s, when the Federal Open Market Committee (FOMC), under the leadership of then-Fed Chairman Paul Volcker, had to raise the policy rate significantly to reduce inflation. At the time, people didn’t believe the Fed would bring inflation down from its high 1970s levels, and inflation expectations weren’t anchored.

“Therefore, Volcker had to work really hard,” Martin said. “He had to really show that he meant it, which meant raising rates a lot and for a long time, until inflation was safely close to a low inflation objective and people basically trusted that it would stay there.”

As the FRED graph below shows, the effective federal funds rate, which typically tracks closely with the FOMC’s target range, peaked at about 19% for a monthly average in the early 1980s.

In addition to lowering inflation, the high interest rates also had other impacts on the economy. As shown in the FRED graph, the early 1980s saw two recessions and high unemployment.

President Musalem mentioned those kinds of consequences in a May 20 speech.

“History tells us that restoring price stability is more costly for the public in terms of forgone employment and economic activity if inflation expectations are not well anchored,” President Musalem said.