Content uploaded by Joseph G. Haubrich
Author content
All content in this area was uploaded by Joseph G. Haubrich on Jan 27, 2014
Content may be subject to copyright.
ECONOMIC COMMENTARY
Infl ation: Noise, Risk, and Expectations
Joseph G. Haubrich and Timothy Bianco
The most frequently cited measures of infl ation expectations, from TIPS-derived indicators to survey-based estimates
like Blue Chip forecasts, have some inherent limitations when it comes to applying them to questions of monetary
policy. Recently, researchers developed a model that takes information from a number of sources and produc-
es estimates of infl ation expectations that are superior to these popular measures in a number of respects. This
Commentary explains how these estimates are better and what they imply for current monetary policy.
ISSN 0428-1276
Number 2010-5
June 28, 2010
If people expect high infl ation, their actions can drive up
prices even faster. That is why the Federal Reserve, with a
mandate for price stability, pays attention to expectations of
infl ation. Determining what people expect, though, presents
more of a challenge than counting the unsold Hondas on a
dealer’s lot. There are useful measures, some based on mar-
ket instruments, some based on surveys, but often combin-
ing tools produces the most useful information.
Surveys, such as the University of Michigan’s Survey of
Consumer Attitudes and Behavior or the Blue Chip Sur-
vey, directly ask people about their expectations. But these
expectations are often only available for standard time
horizons, such as 1 or 10 years, when the relevant policy
questions might concern two, three, or six years. The most
watched market-based measure, the “break-even” rate
derived from Treasury infl ation protected securities (TIPS),
uses the difference between the interest rates on a nominal
Treasury bond (that is, one not indexed to infl ation) and
a TIPS. It too is available only at selected horizons, and it
also picks up differences between the bonds that don’t have
anything to do with infl ation, such as liquidity and risk.
As one way to get around these problems, researchers af-
fi liated with the Federal Reserve Bank of Cleveland have
developed a model that combines data from nominal inter-
est rates, derivatives known as infl ation swaps, and two
different survey measures of infl ation. (For more detail,
see “A New Approach to Gauging Infl ation Expectations,”
Federal Reserve Bank of Cleveland, Economic Commentary,
August 2009.) This Commentary explains how the output
of the model gives us cleaner, more useful estimates of
infl ation expectations and infl ation risk, and what those
expectations might imply for monetary policy.
Expected Infl ation
The Cleveland Fed model of infl ation expectations provides
a simple measure of expected infl ation that has two advan-
tages over the break-even rate derived from TIPS. The fi rst
is that the measure is adjusted for the infl ation risk premium.
Because people don’t like the risk associated with infl ation,
they pay less for a nominal, unprotected bond, which means
it has a higher interest rate. Thus the difference between
nominal bonds and TIPS overstates the expected infl ation
rate. Because the model does not use the difference between
TIPS and Treasuries, it does not capture liquidity differ-
ences along with infl ation expectations.
Figure 1 shows the model’s estimate of 10-year expected
infl ation. Expectations show a gradual decline from the
early 1980s to about 2003, after which they fl uctuate in the
neighborhood just north of 2 percent. The fi nancial crisis
coincided with very low expectations. Despite a rebound in
economic activity since the beginning of 2009, expected in-
fl ation remains very low by historical standards, a bit below
2 percent. Swiftly rising expectations could indicate a Federal
Reserve that had fallen “behind the curve” in fi ghting infl a-
tion—resulting in a need to tighten fast and furious—but that
doesn’t look like the situation we are in.
Infl ation Risk
Adjusting for the infl ation risk premium has an ancillary
advantage: the model explicitly estimates the risk premium,
producing a piece of information not readily available
from either surveys or the TIPS spread. The risk premium
measures how worried people are about infl ation ending up
signifi cantly higher or lower than what they expect.
The infl ation risk premium fl uctuates around half a percent.
(See fi gure 2.) This gives a rule of thumb for adjusting the
break-even infl ation rate to get a better estimate of true
infl ation expectations—take half a percentage point off. The
relatively steady value of the risk premium suggests that
people are not particularly worried about infl ation getting
far from their expectations. This again reinforces the idea
that the public has confi dence that the Federal Reserve is
keeping infl ation in check.
Removing Short-term Effects
Even “purifi ed” expectations of infl ation are not always the
most useful indicators for monetary policy. They refl ect a
lot of short-term infl uences on the price level that are not
really under the control of the monetary authority. In the
short run, oil spills, bad weather, and other shocks mean
that food, energy, and housing prices jump around, and if
infl ation is expected to be higher over the next year, then it
quite likely averages in to a higher expected rate for the next
fi ve years. But higher prices from an oil spill today don’t
really indicate much about monetary policy, and we’d like a
measure which somehow looks beyond such shocks.
Concepts such as the core CPI and the median CPI have
addressed these questions, but they don’t correspond to the
infl ation protection provided by TIPS or the standard sur-
vey questions on infl ation. And it’s not just a measurement
issue. In the short run, there are price pressures, unemploy-
ment effects, and shifts in money demand that move the
price level around in ways that are out of the control of the
central bank. What’s needed is a longer-term measure of
infl ation expectations that purges out the short-term effects.
Figure 1.Ten-Year Expected Infl ation and
Infl ation Risk Premium
Figure 2. Ten-Year Infl ation Risk Premium
Source: Haubrich, Pennachi, Ritchken (2008). Source: Haubrich, Pennachi, Ritchken (2008).
0
1
2
3
4
5
6
7
1985 1990 1995 2000 2005 2010
Percentage yield
Inflation risk premium
Expected inflation
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
1985 1990 1995 2000 2005 2010
Percentage yield
It’s tempting to think that infl ation risk is simply the risk
of high infl ation, but it is rather associated with infl ation
deviating from expectations, whether higher or lower. Put
another way, people anticipate that $10,000 will buy less in
10 years, but they are unsure exactly how much less it will
buy. Similarly, when people hold nominal bonds that are
not protected from infl ation, they are taking a bet on infl a-
tion for the duration of the bond. Sometimes they win the
bet (infl ation is lower than expected), sometimes they lose
(infl ation is higher than expected), but either way they’re
still rolling the dice.
The risk premium can move about for two very different
reasons. First, the amount of infl ation risk may change. In-
fl ation may become more variable—higher highs and lower
lows, and the stakes of misjudging become higher. Secondly,
the stakes may stay the same, but people may become less
tolerant of risk. In other words, the price of infl ation risk
gets higher.
What happens in the rest of the economy may affect
people’s tolerance of risk. If people anticipate a lengthy
recession, for example, they may be less inclined to gamble
on infl ation. While the risk premium can change for differ-
ent reasons, the effect on behavior is similar: nominal bonds
become less attractive investments relative to TIPS, result-
ing in higher interest rates on nominal bonds and lower
rates on TIPS. This increases the difference between them
so the break-even infl ation rate overstates the true expecta-
tion of infl ation.
The forward infl ation rate (fi gure 3) does that. The most
popular version, the so-called “fi ve-year, fi ve-year forward”
answers the question “in fi ve years, what will be the expec-
tation of infl ation over the next fi ve years?” (These forward
rates might look like they adjust for liquidity differences
between TIPS and nominal Treasuries, but they do not. See
Charles Carlstrom and Tim Fuerst, “Expected Infl ation and
TIPS,” Federal Reserve Bank of Cleveland, Economic Com-
mentary, November 2004.) There are several ways of calcu-
lating the forward rate, depending on whether you measure
infl ation expectations from the TIPS break-even rate, from
infl ation swaps, or from the Cleveland model.
Figure 3 shows what a difference the approach makes: The
Cleveland model shows a lower rate than the other two
series over the past several quarters. It stays near 2 per-
cent, while the other measures show a potentially worrying
increase. This increase could imply that the Fed would need
to tighten monetary policy in the near future. However, the
model’s rate shows, if anything, a slight decrease during the
most recent recession. This implies that longer-term infl ation
expectations are still well anchored and the time for tighten-
ing has not yet come.
In part, the popularity of the fi ve-year, fi ve-year forward rate
stems from a thinness in the TIPS market. TIPS are usually
issued in maturities of 5, 10, and 30 years, so it’s easier to
fi nd enough bonds around to calculate that forward spread.
That might not be the most interesting spread, however.
The Cleveland Fed model of infl ation expectations can look
at many maturities, producing a yield curve of expected
infl ation. One approach would be to calculate many forward
rates, but another is to show expected infl ation for the next
30 years, as fi gure 4 does (the slope of the line between any
two points will give an idea of the forward rates).
Consistent with headline CPI numbers, which change
monthly, short-term expectations move around quite a bit.
After about fi ve years the adjustments are tiny. Expectations
of infl ation appear well contained.
Conclusion
Infl ation expectations can provide a clue to people’s behav-
ior, and they can also act as an early warning system for
infl ation. An unexpected increase in infl ation expectations
can serve as a wake-up call to the central bank to reas-
sess whether its policy will keep infl ation in check. The
measures presented here don’t indicate a current problem
for the United States. But watching expectations is not a
complete solution to the problem, and it should not induce
complacency. Expectations take future monetary policy
into account—so expectations of infl ation may remain low
today because people expect a vigorous Fed response in the
near future. Understanding expectations is important, but it
remains only one gauge on the central banker’s dashboard.
Recommended Reading
“A New Approach to Gauging Infl ation Expectations,” by
Joseph G. Haubrich. Federal Reserve Bank of Cleveland,
Economic Commentary (August 2009).
“Estimating Real and Nominal Term Structures using Trea-
sury Yields, Infl ation, Infl ation Forecasts, and Infl ation Swap
Rates,” by Joseph G Haubrich, George Pennacchi, and Peter
Ritchken. Federal Reserve Bank of Cleveland, working
paper no. 0810, November 2008.
Figure 3. Five-Year, Five-Year Forward Infl ation Rate Figure 4. Expected Infl ation Yield Curve
Sources: Haubrich, Pennachi, and Ritchken (2008); Federal Reserve
Board; Bloomberg.
Source: Haubrich, Pennachi, Ritchken (2008).
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
2003 2004 2005 2006 2007 2008 2009 2010
Percentage yields
Inflation swap
Model
TIPS
0
0.5
1
1.5
2
2.5
12345678910 12 15 20 25 30
June 1, 2010
Percent
March 1, 2010
Horizon (years)
Joseph G. Haubrich is a vice president at the Federal Reserve Bank of Cleveland, and Timothy Bianco is a research assistant at the bank.
The views they express here are theirs and not necessarily those of the Federal Reserve Bank of Cleveland or the Board of Governors of the
Federal Reserve System or its staff.
Economic Commentary is published by the Research Department of the Federal Reserve Bank of Cleveland. To receive copies or be placed
on the mailing list, e-mail your request to 4d.subscriptions@clev.frb.org or fax it to 216.579.3050. Economic Commentary is also available
on the Cleveland Fed’s Web site at www.clevelandfed.org/research.
PRSRT STD
U.S. Postage Paid
Cleveland, OH
Permit No. 385
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
Return Service Requested:
Please send corrected mailing label to the
above address.
Material may be reprinted if the source is
credited. Please send copies of reprinted
material to the editor at the address above.