Inflation expectations remain remarkably well anchored

 In Financial News

The inflation shock of the past three years is abating. One reason is that expectations of future inflation continue to remain remarkably well anchored.

The Federal Reserve’s five-year forward breakeven inflation rate—a closely watched measure of expectations—stands at 2.3%, which is below the cyclical peak of 2.61% posted in October 2023.

The average over the past 20 years is 2.37%, and since 2020, which includes the pandemic-era shocks, it has stood at 2.1%.

The reason inflation expectations are so important is that they play a critical role in determining actual inflation. They influence decisions about corporate investment and household consumption, and those decisions, in turn, affect prices and wages. If people think inflation is accelerating, they will act accordingly.

This is particularly the case in developed economies, where inflation expectations are typically the primary driver of inflation. A good rule of thumb, developed by the International Monetary Fund, is that inflation in advanced economies tends to increase by 0.8 of a percentage point for each one percentage point in forward-looking expectations.

It’s a different story in emerging market economies, where past inflation plays a much larger role in shaping inflation expectations. The pass-through in those economies is approximately 0.4%.

Our preferred metric for the United States is the Fed’s five-year breakeven inflation rate. That rate represents a measure of expected inflation derived from five-year Treasury constant maturity securities and five-year Treasury inflation-indexed constant maturity securities. The latest value implies what market participants expect inflation to be in the next five years, on average.

From our vantage point, this market-derived measure provides the best estimation of future inflation captured through actual money on the table in financial markets.

To test our preferred metric, we use a series of public survey data on inflation. One of the best is the New York Fed’s Survey of Consumer Expectations, produced by its Center for Microeconomic Data.

The January survey implies that the public expects a 3% increase in inflation at the one-year horizon, 2.4% at three years and 2.5% at five years.

In our estimation, the major cause of the recent inflation shock was the shutdown of global supply chains during the pandemic, while the persistence is because of a combination of fiscal and monetary policies put in place to address pandemic-era economic distortions.

Despite the inflation shock, public and market-derived inflation expectations have not moved much beyond longer-term averages and are in line with an inflation target of 2% to 2.5%, which we believe will define the post-pandemic inflation environment.

We are confident that the Fed is close to achieving price stability along with maximum sustainable employment, which is the second part of the Fed’s dual mandate.

In addition, we have recently updated our 2024 forecast for the Fed’s preferred measure of inflation—the personal consumption expenditures index—and now expect a return to 2% in the near term, which is in line with the central bank’s inflation target.


This article was written by Joe Brusuelas and originally appeared on 2024-03-05.
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