The most frequently cited measures of inflation expectations, from TIPS-derived indicators to survey-based estimates like Blue Chip forecasts, have some inherent limitations when it comes to applying them to questions of monetary policy. Recently, researchers developed a model that takes information from a number of sources and produces estimates of inflation expectations that are superior to these popular measures in a number of respects. This Commentary explains how these estimates are better and what they imply for current monetary policy.Inflation (Finance)

Joseph G. Haubrich

Timothy Bianco

English

Research Papers in Economics

ECONOMIC COMMENTARY
Inﬂ  ation: Noise, Risk, and Expectations
Joseph G. Haubrich and Timothy Bianco
The most frequently cited measures of inﬂ  ation expectations, from TIPS-derived indicators to survey-based estimates 
like Blue Chip forecasts, have some inherent limitations when it comes to applying them to questions of monetary 
policy. Recently, researchers developed a model that takes information from a number of sources and produc-
es estimates of inﬂ  ation expectations that are superior to these popular measures in a number of respects. This 
Commentary explains how these estimates are better and what they imply for current monetary policy. 
  ISSN 0428-1276
Number 2010-5
June 28, 2010
If people expect high inﬂ  ation, their actions can drive up 
prices even faster. That is why the Federal Reserve, with a 
mandate for price stability, pays attention to expectations of 
inﬂ  ation. Determining what people expect, though, presents 
more of a challenge than counting the unsold Hondas on a 
dealer’s lot. There are useful measures, some based on mar-
ket instruments, some based on surveys, but often combin-
ing tools produces the most useful information.
Surveys, such as the University of Michigan’s Survey of 
Consumer Attitudes and Behavior or the Blue Chip Sur-
vey, directly ask people about their expectations. But these 
expectations are often only available for standard time 
horizons, such as 1 or 10 years, when the relevant policy 
questions might concern two, three, or six years. The most 
watched market-based measure, the “break-even” rate 
derived from Treasury inﬂ  ation protected securities (TIPS), 
uses the difference between the interest rates on a nominal 
Treasury bond (that is, one not indexed to inﬂ  ation) and 
a TIPS. It too is available only at selected horizons, and it 
also picks up differences between the bonds that don’t have 
anything to do with inﬂ  ation, such as liquidity and risk.
As one way to get around these problems, researchers af-
ﬁ  liated with the Federal Reserve Bank of Cleveland have 
developed a model that combines data from nominal inter-
est rates, derivatives known as inﬂ  ation swaps, and two 
different survey measures of inﬂ  ation. (For more detail, 
see “A New Approach to Gauging Inﬂ  ation Expectations,” 
Federal Reserve Bank of Cleveland, Economic Commentary, 
August 2009.) This Commentary explains how the output 
of the model gives us cleaner, more useful estimates of 
inﬂ  ation expectations and inﬂ  ation risk, and what those 
expectations might imply for monetary policy.
Expected Inﬂ  ation
The Cleveland Fed model of inﬂ  ation expectations provides 
a simple measure of expected inﬂ  ation that has two advan-
tages over the break-even rate derived from TIPS. The ﬁ  rst 
is that the measure is adjusted for the inﬂ  ation risk premium. 
Because people don’t like the risk associated with inﬂ  ation, 
they pay less for a nominal, unprotected bond, which means 
it has a higher interest rate. Thus the difference between 
nominal bonds and TIPS overstates the expected inﬂ  ation 
rate. Because the model does not use the difference between 
TIPS and Treasuries, it does not capture liquidity differ-
ences along with inﬂ  ation expectations.
Figure 1 shows the model’s estimate of 10-year expected 
inﬂ  ation. Expectations show a gradual decline from the 
early 1980s to about 2003, after which they ﬂ  uctuate in the 
neighborhood just north of 2 percent. The ﬁ  nancial crisis 
coincided with very low expectations. Despite a rebound in 
economic activity since the beginning of 2009, expected in-
ﬂ  ation remains very low by historical standards, a bit below 
2 percent. Swiftly rising expectations could indicate a Federal 
Reserve that had fallen “behind the curve” in ﬁ  ghting inﬂ  a-
tion—resulting in a need to tighten fast and furious—but that 
doesn’t look like the situation we are in.
Inﬂ  ation Risk
Adjusting for the inﬂ  ation risk premium has an ancillary 
advantage: the model explicitly estimates the risk premium, 
producing a piece of information not readily available 
from either surveys or the TIPS spread. The risk premium 
measures how worried people are about inﬂ  ation ending up 
signiﬁ  cantly higher or lower than what they expect.The inﬂ  ation risk premium ﬂ  uctuates around half a percent. 
(See ﬁ  gure 2.) This gives a rule of thumb for adjusting the 
break-even inﬂ  ation rate to get a better estimate of true 
inﬂ  ation expectations—take half a percentage point off. The 
relatively steady value of the risk premium suggests that 
people are not particularly worried about inﬂ  ation getting 
far from their expectations. This again reinforces the idea 
that the public has conﬁ  dence that the Federal Reserve is 
keeping inﬂ  ation in check.
Removing Short-term Effects
Even “puriﬁ  ed” expectations of inﬂ  ation are not always the 
most useful indicators for monetary policy. They reﬂ  ect a 
lot of short-term inﬂ  uences on the price level that are not 
really under the control of the monetary authority. In the 
short run, oil spills, bad weather, and other shocks mean 
that food, energy, and housing prices jump around, and if 
inﬂ  ation is expected to be higher over the next year, then it 
quite likely averages in to a higher expected rate for the next 
ﬁ  ve years. But higher prices from an oil spill today don’t 
really indicate much about monetary policy, and we’d like a 
measure which somehow looks beyond such shocks. 
Concepts such as the core CPI and the median CPI have 
addressed these questions, but they don’t correspond to the 
inﬂ  ation protection provided by TIPS or the standard sur-
vey questions on inﬂ  ation. And it’s not just a measurement 
issue. In the short run, there are price pressures, unemploy-
ment effects, and shifts in money demand that move the 
price level around in ways that are out of the control of the 
central bank. What’s needed is a longer-term measure of 
inﬂ  ation expectations that purges out the short-term effects.
Figure 1.Ten-Year Expected Inﬂ  ation and 
 Inﬂ  ation Risk Premium
Figure 2. Ten-Year Inﬂ  ation Risk Premium
Source: Haubrich, Pennachi, Ritchken (2008). Source: Haubrich, Pennachi, Ritchken (2008).
0
1
2
3
4
5
6
7
1985 1990 1995 2000 2005 2010
Percentage yield
Inﬂation risk premium
Expected inﬂation
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
1985 1990 1995 2000 2005 2010
Percentage yield
It’s tempting to think that inﬂ  ation risk is simply the risk 
of high inﬂ  ation, but it is rather associated with inﬂ  ation 
deviating from expectations, whether higher or lower. Put 
another way, people anticipate that $10,000 will buy less in 
10 years, but they are unsure exactly how much less it will 
buy. Similarly, when people hold nominal bonds that are 
not protected from inﬂ  ation, they are taking a bet on inﬂ  a-
tion for the duration of the bond. Sometimes they win the 
bet (inﬂ  ation is lower than expected), sometimes they lose 
(inﬂ  ation is higher than expected), but either way they’re 
still rolling the dice.
The risk premium can move about for two very different 
reasons. First, the amount of inﬂ  ation risk may change. In-
ﬂ  ation may become more variable—higher highs and lower 
lows, and the stakes of misjudging become higher. Secondly, 
the stakes may stay the same, but people may become less 
tolerant of risk. In other words, the price of inﬂ  ation risk 
gets higher.
What happens in the rest of the economy may affect 
people’s tolerance of risk. If people anticipate a lengthy 
recession, for example, they may be less inclined to gamble 
on inﬂ  ation. While the risk premium can change for differ-
ent reasons, the effect on behavior is similar: nominal bonds 
become less attractive investments relative to TIPS, result-
ing in higher interest rates on nominal bonds and lower 
rates on TIPS. This increases the difference between them 
so the break-even inﬂ  ation rate overstates the true expecta-
tion of inﬂ  ation.The forward inﬂ  ation rate (ﬁ  gure 3) does that. The most 
popular version, the so-called “ﬁ  ve-year, ﬁ  ve-year forward” 
answers the question “in ﬁ  ve years, what will be the expec-
tation of inﬂ  ation over the next ﬁ  ve years?” (These forward 
rates might look like they adjust for liquidity differences 
between TIPS and nominal Treasuries, but they do not. See 
Charles Carlstrom and Tim Fuerst, “Expected Inﬂ  ation and 
TIPS,” Federal Reserve Bank of Cleveland, Economic Com-
mentary, November 2004.) There are several ways of calcu-
lating the forward rate, depending on whether you measure 
inﬂ  ation expectations from the TIPS break-even rate, from 
inﬂ  ation swaps, or from the Cleveland model.
Figure 3 shows what a difference the approach makes: The 
Cleveland model shows a lower rate than the other two 
series over the past several quarters. It stays near 2 per-
cent, while the other measures show a potentially worrying 
increase. This increase could imply that the Fed would need 
to tighten monetary policy in the near future. However, the 
model’s rate shows, if anything, a slight decrease during the 
most recent recession. This implies that longer-term inﬂ  ation 
expectations are still well anchored and the time for tighten-
ing has not yet come.
In part, the popularity of the ﬁ  ve-year, ﬁ  ve-year forward rate 
stems from a thinness in the TIPS market. TIPS are usually 
issued in maturities of 5, 10, and 30 years, so it’s easier to 
ﬁ  nd enough bonds around to calculate that forward spread. 
That might not be the most interesting spread, however. 
The Cleveland Fed model of inﬂ  ation expectations can look 
at many maturities, producing a yield curve of expected 
inﬂ  ation. One approach would be to calculate many forward 
rates, but another is to show expected inﬂ  ation for the next 
30 years, as ﬁ  gure 4 does (the slope of the line between any 
two points will give an idea of the forward rates).
Consistent with headline CPI numbers, which change 
monthly, short-term expectations move around quite a bit. 
After about ﬁ  ve years the adjustments are tiny. Expectations 
of inﬂ  ation appear well contained.
Conclusion
Inﬂ  ation expectations can provide a clue to people’s behav-
ior, and they can also act as an early warning system for 
inﬂ  ation. An unexpected increase in inﬂ  ation expectations 
can serve as a wake-up call to the central bank to reas-
sess whether its policy will keep inﬂ  ation in check. The 
measures presented here don’t indicate a current problem 
for the United States. But watching expectations is not a 
complete solution to the problem, and it should not induce 
complacency. Expectations take future monetary policy 
into account—so expectations of inﬂ  ation may remain low 
today because people expect a vigorous Fed response in the 
near future. Understanding expectations is important, but it 
remains only one gauge on the central banker’s dashboard.
Recommended Reading
“A New Approach to Gauging Inﬂ  ation Expectations,” by 
Joseph G. Haubrich. Federal Reserve Bank of Cleveland, 
Economic Commentary (August 2009). 
“Estimating Real and Nominal Term Structures using Trea-
sury Yields, Inﬂ  ation, Inﬂ  ation Forecasts, and Inﬂ  ation Swap 
Rates,” by Joseph G Haubrich, George Pennacchi, and Peter 
Ritchken. Federal Reserve Bank of Cleveland, working 
paper no. 0810, November 2008.
Figure 3. Five-Year, Five-Year Forward Inﬂ  ation Rate Figure 4. Expected Inﬂ  ation Yield Curve
Sources: Haubrich, Pennachi, and Ritchken (2008); Federal Reserve 
Board; Bloomberg.
Source: Haubrich, Pennachi, Ritchken (2008).
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
2003 2004 2005 2006 2007 2008 2009 2010
Percentage yields
Inﬂation swap
Model
TIPS
0
0.5
1
1.5
2
2.5
123456789 1 0 1 2 1 5 2 0 2 5 3 0
June 1, 2010
Percent
March 1, 2010
Horizon (years)Joseph G. Haubrich is a vice president at the Federal Reserve Bank of Cleveland, and Timothy Bianco is a research assistant at the bank. 
The views they express here are theirs and not necessarily those of the Federal Reserve Bank of Cleveland or the Board of Governors of the 
Federal Reserve System or its staff.
Economic Commentary is published by the Research Department of the Federal Reserve Bank of Cleveland. To receive copies or be placed 
on the mailing list, e-mail your request to 4d.subscriptions@clev.frb.org or fax it to 216.579.3050. Economic Commentary is also available 
on the Cleveland Fed’s Web site at www.clevelandfed.org/research. 
PRSRT STD
U.S. Postage Paid
Cleveland, OH
Permit No. 385
  Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
Return Service Requested:
Please send corrected mailing label to the 
above address.
Material may be reprinted if the source is 
credited. Please send copies of reprinted 
material to the editor at the address above.

Inflation: noise, risk, and expectations

http://www.clevelandfed.org/research/commentary/2010/2010-5.pdf

Inflation: noise, risk, and expectations

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics