Inflation (Finance) ; Rational expectations (Economic theory)

Jeremy M. Piger

English

Research Papers in Economics

November 2005 MonetaryTrends
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
T
he University of Michigan’s Survey of Consumers
reported a drastic decline in consumer confidence
following the devastating effects of Hurricane
Katrina. This crumbling confidence was widely reported,
and its significance as an indicator of economic weakness
debated. Less well publicized was the large increase in
expectations of future inflation that was also recorded in
this survey. For example, at the end of August, just before
Hurricane Katrina, respondents in the Michigan survey
were expecting the inflation rate over the subsequent 12
months to be 3.1 percent. However, by the end of
September, the same measure of inflation expectations was
4.3 percent. As the black line in the accompanying chart
shows, this increase in inflation expectations is large by
historical precedent and brings one-year-ahead inflation
expectations to a level not seen since 1990.
Inflation expectations give a reading of how credible
the public believes monetary policymakers are in their
commitment to fight inflation; as a result these expecta-
tions are an important gauge used in the practice of mon-
etary policy. That is, if the public believes monetary policy-
makers are credible in their stated goal of keeping inflation
low and stable, then inflation expectations will stay low
and stable. One reason credibility is important is that con-
taining inflation expectations can be a first step in contain-
ing inflation itself. This is because expectations of higher
future inflation might be negotiated into various sorts of
pricing contracts, such as labor contracts, thereby creating
the expected inflation.  
To interpret the rise in inflation expectations from the
Michigan survey, a natural first question is, to what extent
is this measure a reliable predictor of future inflation?
After all, this survey is conducted by polling consumers
who have no special expertise or sophistication in fore-
casting inflation, raising a legitimate question of how
seriously one should take the results. However, economists
N. Gregory Mankiw, Ricardo Reis, and Justin Wolfers
have shown that, when evaluated over the past 20 years,
the median survey response from the Michigan survey
was at least as accurate of a forecast of future inflation
as those produced by professional forecasters.1
Given this, should monetary policymakers at the Federal
Reserve be concerned that inflation expectations are getting
out of control, suggesting they have been too slow to tighten
policy in recent years? To evaluate this question, it is useful
to look not just at expectations of inflation over the next year,
but also over longer horizons. As the green line in the figure
shows, expectations of inflation from the Michigan survey
over the horizon of the next 5 to 10 years have increased only
slightly in recent months and are not at abnormally high
levels relative to those seen in the past several years. This diver-
gence between shorter and longer horizon inflation expecta-
tions suggests that the rise in inflation expected over the next
year is being driven by temporary factors, such as increases
in energy prices, and not by a loss of confidence in the ability
or resolve of Federal Reserve policymakers to control infla-
tion more broadly. This is good news for the Federal Reserve,
as it suggests the public is convinced policymakers are taking,
and will continue to take, appropriate actions to keep infla-
tion low over longer horizons.
—Jeremy M. Piger
1N.G. Mankiw, R. Reis, and J. Wolfers, “Disagreement about Inflation
Expectations,” NBER Macroeconomics Annual 2003.
Are Inflation Expectations Rising from the Ashes?
research.stlouisfed.org
Consult ALFRED™, our new source of vintage economic data, at research.stlouisfed.org/tips/alfred/.
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Short- and Long-Term Inflation Expectations from
the University of Michigan’s Survey of Consumers
1 Year Ahead
5-10 Years Ahead

Are inflation expectations rising from the ashes?

http://research.stlouisfed.org/publications/mt/20051101/cover.pdf

Are inflation expectations rising from the ashes?

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Research Papers in Economics