What the heck are inflation expectations, anyway? You won't find the term in any of the major economic data releases put out by the government. Yet whether inflation expectations are rising or falling may turn out to be a critical factor in determining how far and how fast the Federal Reserve raises interest rates.
That, at least, is the new line coming out of the Fed these days. Inflation expectations -- a bit of a touchy-feely concept -- represent the beliefs of consumers, investors, corporate execs, and economists about how fast prices will rise in the future. To new Fed Chairman Ben S. Bernanke, inflation expectations are a key indicator. If people believe inflation will stay low, the Fed can afford to relax a bit. But if the masses start anticipating faster inflation, the odds are greater that the Fed will need to hit them with higher rates even if actual price hikes remain moderate.
The good news, for now, is that "long-term inflation expectations [are] apparently anchored at low levels," as Bernanke noted in a Mar. 20 speech. By some measures, inflation expectations are a bit lower than a year ago. That suggests the Fed will be more likely to stop raising rates sooner rather than later after its expected quarter-point hike, to 4.75%, at the Mar. 27-28 meeting of the Federal Open Market Committee (FOMC).
Bernanke has some critical allies on the policy-setting FOMC, including Janet L. Yellen, president of the Federal Reserve Bank of San Francisco. On Mar. 13, Yellen gave an entire speech about the importance of inflation expectations. She also noted that "clear communication of a numerical long-run inflation objective" -- something Bernanke supports -- may help keep expectations in line.
How are beliefs about future inflation measured? One way is to ask economists what they think is going to happen. According to the Philadelphia Fed's Survey of Professional Forecasters, economists expect consumer inflation to average 2.5% over the next 10 years, only a tad above their 2.45% forecast of a year earlier. That's not very worrisome.
Another way to judge expectations is to look at the behavior of investors -- in particular, the people who buy Treasury Inflation-Protected Securities (TIPS), which are indexed to inflation to give investors a fixed real return. The spread between 10-year TIPS and regular 10-year Treasuries, a measure for expected average annual inflation over the next decade, is 2.68%, according to calculations by Timothy S. Fuerst, an economics professor at Bowling Green State University in Ohio. That's slightly below the 2.72% of a year earlier.
The danger, of course, is that expectations about future prices might jump, forcing the Fed to raise rates sharply to maintain its credibility as an inflation fighter. That's what happened in the 1970s, when the public's lack of faith in the Fed's inflation-fighting resolve sent prices -- and expectations of future inflation -- spiraling out of control after the oil shock.
Contrast that with today. The Fed has built credibility by both aggressively fighting inflation and communicating its commitment to price stability. As a result, even as energy prices skyrocketed in recent years, inflation expectations hardly budged, and non-energy inflation stayed relatively low.
The emphasis on expectations could also be Bernanke's way of getting people used to the more controversial idea of setting inflation targets. After all, if the Fed is going to react to beliefs about future inflation, it's only natural for the central bank eventually to specify explicitly the acceptable level of inflation.
But that's a debate for later. For now, with such benign expectations for inflation all around, the Fed has finally bought itself a little breathing room.
By Catherine Yang