According to consumer price measures like the CPI, inflation has recently jumped up a notch. What those measures don’t tell us is whether the increase will persist. In this Commentary, we look at a measure that does. The measure incorporates data on past inflation rates, surveys of expected inflation, inflation swaps, and a variety of interest rates. It provides estimates of inflation, along with expected inflation and real interest rates. A look at the measure’s estimates suggests that the recent increases in inflation are likely to be temporary.Inflation targeting ; Consumer price indexes

Joseph G. Haubrich

English

Research Papers in Economics

ECONOMIC COMMENTARY
Number 2011-20
October 5, 2011
The Future of Inﬂ  ation
Joseph G. Haubrich
According to consumer price measures like the CPI, inﬂ  ation has recently jumped up a notch. What those measures 
don’t tell us is whether the increase will persist. In this Commentary, we look at a measure that does. The measure 
incorporates data on past inﬂ  ation rates, surveys of expected inﬂ  ation, inﬂ  ation swaps, and a variety of interest rates. It 
provides estimates of inﬂ  ation, along with expected inﬂ  ation and real interest rates. A look at the measure’s estimates 
suggests that the recent increases in inﬂ  ation are likely to be temporary. 
  ISSN 0428-1276
Recently, inﬂ  ation, as measured by the headline Consumer 
Price Index, has been running at a sustained clip—prices 
have risen over 4.5 percent in ﬁ  ve of the past seven 
months, and in July they increased at an annualized rate 
of 6.2 percent. How worried should we be that the recent 
numbers represent a sustained increase in inﬂ  ation? After 
all, prices can be quite variable, and in fact they fell in 
June (2.6 percent). 
Experts have different opinions about the danger. Often, 
their opinion depends on which economic theory they 
adhere to. Some people point to the large amounts of li-
quidity (and correspondingly high monetary base) provid-
ed by the Federal Reserve over the past several years and 
predict high inﬂ  ation. Others point to the inverse relation-
ship between inﬂ  ation and unemployment and predict, if 
anything, dangerously low inﬂ  ation.
In this Commentary, we look at what we can learn about the 
behavior of inﬂ  ation from the effects it has on ﬁ  nancial mar-
kets and people’s expectations. Looking at these effects will 
provide some perspective on the recent price increases from 
the standpoint of monetary policy. If markets and consum-
ers believe price increases are temporary, the central bank 
can be less concerned that inﬂ  ation will be a problem. 
Of course, knowing that price increases are temporary 
doesn’t make ﬁ  lling up your gas tank or grocery cart today 
any less painful. But for budgeting purposes, it helps to 
know the pain won’t last long enough to cut into your 
daughter’s college fund. Just as important, knowing that 
prices won’t continue to rise can prevent the central bank 
from ﬁ  ghting an imaginary monster, needlessly tightening 
policy.and Expectations: A New Approach to Gauging Inﬂ  ation 
Expectations,” and for more technical detail, “Inﬂ  ation 
Expectations, Real Rates, and Risk Premia: Evidence from 
Inﬂ  ation Swaps.”) 
This rather complicated procedure has some advantages 
over the simpler and more common measure of inﬂ  ation 
expectations that comes from the ﬁ  nancial markets, the 
breakeven rate. Breakeven rates often overstate inﬂ  ation 
expectations because they also include a risk factor. The risk 
factor slips in because inﬂ  ation is uncertain. The additional 
information in the Cleveland Fed’s approach gives a purer 
measure of expectations. 
More importantly for our purposes here, the Cleveland 
Fed’s approach also yields a pattern for inﬂ  ation that can be 
used to gauge if recent increases are a temporary aberration 
or the start of a dangerous upward trend. A simple way to 
state the problem would be to ask if the changes in inﬂ  a-
tion are permanent or temporary. This is hardly a problem 
unique to economics: Is a warm spring global warming or 
just weather? Were Republican electoral victories in 2010 a 
generational shift or a minor midterm correction? Did the 
Cleveland Browns’ fast start in 2011 presage a resurgent 
franchise or just a lucky streak that will leave fans disap-
pointed by playoff time? 
The question is not really either/or, however, because a 
higher inﬂ  ation rate will often be a mixture of both: some 
part of the increase in prices will fade away relatively quick-
ly, but a bit will hang around for quite a while. In this re-
gard, inﬂ  ation has two components, a short-term, temporary 
effect and a long-term, permanent factor. Watching inﬂ  ation 
over a long time period would reveal which factor was more 
important. We would see if inﬂ  ation stayed high once it 
started moving higher or if it tended to rapidly drop back to 
a more normal level. With this experience, you could then 
Figure 1.  One-Month Expected Inﬂ  ation 
and CPI
Figure 2.  Expected Inﬂ  ation and Its 
Central Tendency
–20
–15
–10
–5
0
5
10
15
1982 1986 1990 1994 1998 2002 2006 2010
CPI annualized change
Percent
Model-implied 
expected inﬂation
–6
–4
–2
0
2
4
6
8
10
12
1982 1985 1988 1991 1994 1997 2000 2003 2006 2009
Expected inﬂation
Percent
Central tendency
Uncovering Inﬂ  ation
People probably follow prices more closely than any other 
kind of economic data. Still, we have no sureﬁ  re way of tell-
ing when a streak of rising prices will get worse or persist. 
Inﬂ  ation is by deﬁ  nition a rise in prices in general. Econo-
mists use a number of approaches to judge whether the 
latest data on prices indicate that inﬂ  ation will persist or not. 
One of the more popular approaches looks at “core” inﬂ  a-
tion. Core inﬂ  ation measures strip out food and energy 
prices, or even larger portions of the consumer market 
basket, from the price measure. This has its justiﬁ  cations, 
in that dropping the most variable prices can often better 
reveal the underlying trend. Still, since people buy gas and 
milk, there is some logic in looking at overall prices, not just 
a subset. Some economists ﬁ  nd fault with core measures for 
this reason.1 
Another drawback of focusing on the core is that most 
surveys and ﬁ  nancial products that are tied to inﬂ  ation use 
the headline CPI as the reference point, not the core CPI. 
These surveys and products can give important clues about 
the future of inﬂ  ation. 
Surveys and ﬁ  nancial products can provide another, albeit 
indirect, approach to gauging future inﬂ  ation. Instead of 
looking backwards at past prices, they involve a forecast of 
inﬂ  ation. Surveys that ask about people’s inﬂ  ation expec-
tations are one example. Financial instruments that have 
payouts which depend on inﬂ  ation, such as inﬂ  ation swaps, 
are another. 
We’ve described in several articles one approach we take at 
the Federal Reserve Bank of Cleveland. This approach uses 
data on past inﬂ  ation rates, survey measures of expected 
inﬂ  ation, inﬂ  ation swaps, and a variety of interest rates. 
From all this, it backs out measures of inﬂ  ation, expected 
inﬂ  ation, and real interest rates. (See “Inﬂ  ation: Noise, Risk, 
Sources: Haubrich, Pennacchi, and Ritchken (2011); Bureau of Labor Statistics. Source: Haubrich, Pennacchi, and Ritchken (2011).make an informed guess about the recent changes and how 
permanent or transitory they are expected to be. 
However, things aren’t always as simple as they seem, 
and this holds true for inﬂ  ation. There are in fact different 
degrees of “transitory”—does the effect disappear right away,   
or does it or hang around for a few months? And the under-
lying permanent level of inﬂ  ation may itself slowly change 
over time. 
The Cleveland Fed’s approach to inﬂ  ation builds on this 
underlying pattern (or “process”) but is somewhat more 
complicated, with more than just two factors. In our model, 
actual inﬂ  ation is expected inﬂ  ation plus a very temporary 
random shock. 
Expected inﬂ  ation is somewhat less transitory: it is mean 
reverting. That is, shocks move it up and down, but the 
expected rate of inﬂ  ation slowly tends to move back toward 
a longer-run average, termed the central tendency. That cen-
tral tendency itself moves around, slowly tending toward the 
long-run historical mean of inﬂ  ation in the United States. 
The path of inﬂ  ation might then look something like the 
path of a small airplane, buffeted by winds, gradually re-
turning to its ﬂ  ight path, which is itself moving around. 
Figures 1 and 2 show how this pattern plays out. Figure 
1 plots monthly actual annualized inﬂ  ation (that is, what 
the inﬂ  ation rate would be if prices rose at that rate for the 
entire year) and inﬂ  ation expectations (again, monthly, at an 
annualized rate). Actual inﬂ  ation is much more variable than 
expected inﬂ  ation. 
That constitutes a lesson in itself, delivering a warning to 
expect the unexpected, and that reality does not always 
match expectations. How big those surprises are varies over 
time, however, and one can clearly see the great moderation 
of the 1990s reﬂ  ected in the lower variability of inﬂ  ation. 
Despite the many ups and downs, however, inﬂ  ation does 
seem to vary around the expected level. 
Figure 2 again shows the monthly expected inﬂ  ation, this 
time pairing it with the central tendency. There are several 
things to notice. Perhaps the most obvious is that the central 
tendency of inﬂ  ation has declined greatly over the past 30 
years. In the 1980s it hit above 10 percent. Now, it is well 
below 2 percent. 
Expected inﬂ  ation shows less of a downward trend, but it 
too shows a gradual decrease from the great inﬂ  ation of 
the 1970s. Monthly expected inﬂ  ation also generally varies 
more than the central tendency, particularly in recent years. 
Expected inﬂ  ation has moved up recently, but the central 
tendency has moved down. 
The Road Ahead
What do these patterns mean for the future path of inﬂ  a-
tion? As always, prediction is difﬁ  cult, particularly about the 
future. But to the extent that inﬂ  ation tracks toward expect-
ed inﬂ  ation, and expected inﬂ  ation tracks toward the central 
tendency, which tends to move slowly, it is the central ten-
dency that gives the best view of inﬂ  ation in the medium to 
longer term. To the extent that actual inﬂ  ation varies more 
than expected inﬂ  ation and expected inﬂ  ation varies more 
than the central tendency, there is reason to think that the 
high rates we have been experiencing are temporary, soon 
to be replaced with a different cut from the deck. 
One way to think about this is the notion of “half-life.” The 
term originated in physics, where it describes the time it 
takes for half of a radioactive substance to decay. In the case 
of inﬂ  ation, it is the time it takes for half of the effect of the 
initial price shock to wear off. If inﬂ  ation temporarily jumps 
up by 1 percentage point, how long until it is just half a per-
centage point above the average? Expected inﬂ  ation drops 
back quickly, with a half life of only three months. Put an-
other way, one year later, the effects of the shock would be 
barely noticeable (one half of a half of a half of a half, or a 
sixteenth). The central tendency moves much more slowly, 
returning halfway to its mean only after 12 years.
This is perhaps a long way of saying that the recent high 
levels of inﬂ  ation look to be temporary, and that the central 
tendency provides a better view of where inﬂ  ation is headed 
in the medium to long term. 
But, as always in economics, there is an “on the other 
hand.” Actual inﬂ  ation and expectations revert back toward 
the central tendency—but in times of major historic shifts, 
such as the end of the great inﬂ  ation in the early 1980s, it 
was the central tendency that slowly came down, as central 
banks built up credibility by keeping inﬂ  ation (relatively) 
low for a while. Furthermore, there is a danger of think-
ing about inﬂ  ation as something inexorable, like radioac-
tive decay. Instead, it is the outcome of decisions by actual 
people, and embeds expectations about what decisions will 
be made, particularly decisions by the central bank. 
With stable prices a mandated goal of the Federal Reserve, 
understanding how inﬂ  ation adjusts is a top priority. An 
examination of the data shows that most of the recent 
increases are likely to be temporary, and the longer-term 
component of inﬂ  ation is much lower than recent price 
increases suggests. 
Footnote
1. For example, Bullard (2011).Joseph G. Haubrich is a vice president and economist at the Federal Reserve Bank of Cleveland. The views he expresses here are his and 
not necessarily those of the Federal Reserve Bank of Cleveland, the Board of Governors of the Federal Reserve System, or Board staff.
Economic Commentary is published by the Research Department of the Federal Reserve Bank of Cleveland. To receive copies or be placed 
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Recommended Reading
“Inﬂ  ation: Noise, Risk, and Expectations: A New Approach to 
Gauging Inﬂ  ation Expectations,” by Timothy Bianco and Joseph 
G. Haubrich, 2010. Federal Reserve Bank of Cleveland, Economic 
Commentary.
“Inﬂ  ation Expectations, Real Rates, and Risk Premia: Evidence 
from Inﬂ  ation Swaps,” by Joseph G. Haubrich, George Pennac-
chi, and Peter Ritchken, 2011. Federal Reserve Bank of Cleve-
land, working paper no. 11-07.
“Measuring Inﬂ  ation: The Core Is Rotten,” by James Bullard, 
2011. Federal Reserve Bank of St. Louis, Review.

The future of inflation

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The future of inflation

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