Inflation Expectations

Eakinomics: Inflation Expectations The June data on Consumer Price Index (CPI) inflation will be released tomorrow morning at 8:30, giving us insight into the evolution of actual inflation. Yesterday, however, the Federal Reserve Bank of New York (New York Fed) released the June information on inflation expectations, which is reproduced below. As one can see, expectations of inflation one year from now ticked up by 0.2 percentage points to 6.8 percent. Hmmm. In contrast, expectations of inflation three years from now dropped to 3.6 percent from 3.9 percent. What should one make of this? In general, inflation expectations are an important part of the challenge of taming inflation itself. If people do not expect there to be inflation, then the process of knocking down inflation is simply to reduce demand so that fewer dollars chase the same goods and price pressures decline. Typically, the Fed would do this by raising interest rates, making credit-based purchases (houses, cars, etc.) less attractive, and lowering demand. Having people expect inflation throws a spanner in the works. Suppose that people expect 6 percent inflation. They will try to protect themselves from this by trying to get their incomes higher by 6 percent – negotiating for higher wages, writing contracts that have prices with a 6 percent markup, and so forth. To bring down inflation, the Fed must lean hard enough to discourage not only the inflation itself, but also the expected inflation. If a lot of people are losing their jobs or closing their businesses, demanding higher wages and payments looks like less of a good idea. Taken too far, this might mean the Fed leans hard enough to push the economy into recession. These particular data are interesting because one-year expectations went up, while three-year expectations went down. The latter is good news from the Fed’s perspective, but the former is not. The Fedsters (the chair, vice-chair, Board of Governors, regional Fed presidents) have been talking up a storm since the turn of the year about how tough they are going to be on inflation. In addition, they front-loaded some planned rate increases. Presumably, these were efforts to convince people that the Fed was serious, and inflation would not persist – i.e., they were efforts to manage inflation expectations. From this perspective, the June uptick is more than a little disappointing. One possible question about these survey-based results is: Who are these people anyway, and what do they know about inflation? Well, almost 1,500 consumers took this survey – people like you. But there does not appear to be any reason to question their inflation acumen. The chart below shows a second measure of inflation expectation derived from comparing the returns on regular and inflation-protected Treasury securities. These five-year expectations are based on the trading of market professionals – presumably well-informed and cognizant of the inflation risks. They appear to be little different from the three-year expectations from the New York Fed, giving some confidence in the accuracy of the latter. A big part of taming inflation will be taming inflation expectations. The job is far from complete.