The Dynamics of Long-Run Inflation Expectations: A Market-Based Perspective

Abstract

This article analyzes market-based probability distributions for long-run inflation expectations derived from inflation derivatives. We construct forward-looking distributions for five-year-ahead inflation to assess the likelihood that inflation will fall above, below, or near the Federal Reserve’s 2 percent target. By examining the mean, volatility, and skewness of these distributions, we document how expectations have evolved since the onset of the COVID-19 pandemic. To assess the reliability of market-based measures, we compare our results with alternative data sources. We highlight the elevated probability of inflation exceeding the 2 percent target that persisted shortly after the COVID-19 pandemic. The findings underscore the importance of market-based tools in capturing nuanced inflation dynamics and informing policy and financial decisions.

Introduction

Long-run inflation expectations are a key determinant of monetary policy decisions and financial market dynamics. While most existing measures focus on point estimates—such as the expected average inflation rate—we complement this literature by constructing full probability distributions of future inflation. This approach captures not only the central tendency but also the likelihood of a wide range of inflation outcomes, including extreme scenarios.

Point forecasts convey limited information about uncertainty and tail risks. In contrast, probability densities offer a richer perspective, describing the full distribution of possible outcomes and the relative likelihood of each. This allows policymakers and market participants to better understand the risks of extreme inflation—either very high or very low—that may materialize over time.

In this article, we analyze the forward distribution of inflation, focusing on its mean, variance, and skewness. These moments provide insight into the level, uncertainty, and asymmetry of inflation expectations. Our analysis relies on market-based information extracted from the prices of inflation derivatives. Specifically, we use inflation caps and floors, which are options that provide payouts when inflation rises above or falls below a specified threshold. These derivatives embed investor beliefs about future inflation rates.

In addition to estimating these distributions, we assess the data quality and key assumptions underlying the market-based approach. We evaluate how these assumptions affect inference, particularly in the post-COVID period when inflation uncertainty has increased. By comparing pre-pandemic stability with the volatility of recent years, we highlight the value and limitations of these market-derived measures.