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Consumers expect inflation of 3.2 percent in the next five-to-10 years. Investors expect 2.8 percent.

Who’s right? And why should we care?

We don’t know the answer to the first question. I will try to answer the second in 800 words or less.

When I listen to academics and Federal Reserve policy makers talk about inflation expectations, seemingly imbuing them with a life of their own, it sounds like something out of a textbook that’s suited for an econometric model.

What a surprise to learn that it is! Inflation expectations evolved from something called rational expectations theory, the idea that people make economic decisions based on previous experience and expectations about the future.

Rather than a school of economic thought, rational expectations should be viewed as “a ubiquitous modeling technique used widely throughout economics,” economist Tom Sargent explains in an essay in the Concise Encyclopedia of Economics.

He should know. Sargent, a professor at New York University, is one of the pioneers of rational expectations theory, on which much of modern macroeconomics is based. It underlies efficient-markets theory, the permanent income hypothesis and the augmented Phillips curve, which describes the relationship between inflation and unemployment.

The theory is a central tenet underlying the debate about government intervention in the economy. Opponents of fiscal stimulus claim that the public’s expectation of higher taxes will offset any temporary benefit from government spending.


That’s because human beings behave rationally. Never mind that we just lived through the mother of all housing bubbles, with folks buying homes they couldn’t afford with loans they couldn’t repay. Human beings are rational. Quod erat demonstrandum.

If businesses expect raw materials prices to rise, they will buy more today and stockpile them for the future.

The notion of inflation expectations affecting behavior has been extended to consumers, erroneously in most cases. If households expect gasoline prices to rise, they don’t go out and purchase a 1,000-gallon storage tank for the front lawn. At best, most of us keep two gallons in a gas can to fill the lawn mower.

“Who do I negotiate with when I fill the tank?” says Jim Glassman, senior economist at JPMorgan Chase & Co. “I’m a price taker. The more we are price takers, the less inflation expectations matter.”

Which Prices?

Years ago, I was so agitated by the Fed’s fixation on inflation expectations at the expense of policies that affect actual inflation, I decided to test my theory that the public doesn’t know or doesn’t care.

I conducted a simple survey on inflation, present and future, that confirmed my suspicions. You can read about it here.

For their part, businesses care a lot about prices: the prices of things they buy and sell.

“A rise in raw materials is a sign of inflation to the businessman,” says Sandra Westlund-Deenihan, president and design engineer at Quality Float Works Inc., a 96-year-old family run business in Schaumburg, Illinois, that makes liquid level-control devices.

The company adjusted to soaring input costs by ordering in bulk, shopping around, even asking customers to send customized boxes “so we aren’t bearing the shipping costs,” she says.

Different Strokes

Right now any manufacturer that purchases crude materials - - everything from cotton to steel scrap -- is bound to have an inflated set of inflation expectations. So will consumers whose major purchases are food and energy.

“I can’t believe the news there’s no inflation,” Westlund-Deenihan says. “They’re not touching it. We have a bottom line.”

Lastly, financial markets telegraph investors’ inflation expectations via the spread between nominal and inflation-indexed Treasuries. This measure is imperfect as well, influenced as it is by preferences for the most liquid (nominal) Treasuries when safety concerns are paramount.

Inflation expectations, then, mean different things to different people.

I did find two academics to walk me through the Fed’s inflation expectations fog. Former Fed governor Randall Kroszner, now a professor at the University of Chicago’s Booth School of Business, and Michael Bordo, an economics professor at Rutgers University in New Brunswick, New Jersey, patiently explained a situation where the public’s inflation expectations, if unaligned with the Fed’s goal, could have an undesirable effect on the economy.

Doubting Thomases

Three decades ago, when Paul Volcker arrived at the Fed determined to wring inflation out of the system, businessmen didn’t believe him. They’d heard that story before. They offered employees wage increases in line with past inflation, not with what Volcker promised for the future.

When inflation fell, companies found themselves caught between higher costs and lower prices. The cost structure forced many out of business. Others had to fire workers. The recession was deeper than it would have been if the public had been convinced of Volcker’s intent.

Point taken, although I’m still not sure inflation expectations are as important as they’re cracked up to be.

What is important is Fed credibility. And actions speak louder than words. Policy makers may be comfortable that inflation expectations are well anchored and the output gap, or degree of economic slack, is large enough to drive a semi through. But overnight interest rates at zero are creating speculative demand for real and financial assets. The Fed ignores these expectations at its own risk.

(Caroline Baum, author of “Just What I Said,” is a Bloomberg News columnist. The opinions expressed are her own.)

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