Compared to While transparency and communication are important, RBI should focus on instilling trust in monetary policy, besides gaining a better understanding of how consumers incorporate and update inflation expectations and also the role of socio-demographic characteristics in anchoring these.
Otherwise, inflation-expectation surveys may be yet another case of people not putting their money where their mouths are. Never miss a story!
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Remove some to bookmark this image. You are now subscribed to our newsletters. Premium Premium Aha! A pattern! And some mathematics! Premium Premium A look at the metaverse through four lenses of a metamo This is an estimate of inflation expectations for the five year period that begins five years from the present. These market-based indicators are, however, imperfect measures of inflation expectations, as they combine true expectations for inflation with a risk premium —compensation that investors require to hold securities with value that is susceptible to the uncertainty of future inflation.
The easiest way is to use its monetary policy tools to achieve and maintain inflation around 2 percent. However, the Fed can also influence expectations with its words, particularly by elaborating on how it intends to use its monetary policy tools in the future to achieve the 2 percent goal. To this end, in August , the Fed modified its monetary policy framework. It is sticking with its 2 percent inflation target but now says that it intends to offset periods of below-2 percent inflation with periods of above-2 percent inflation, an approach it is calling Average Inflation Targeting AIT.
In its old framework, if inflation fell below the 2 percent target, the Fed pledged to try to get it back to target without compensating for the period of inflation shortfall. The change makes explicit that, following a period in which inflation has fallen short of target for a time, the Fed will accept and even encourage periods of above-2 percent inflation going forward, discouraging a decline in inflation expectations.
When inflation expectations are anchored at target, it is easier for the Fed to steer inflation to 2 percent. If inflation expectations move down from 2 percent, inflation could fall as well—a reverse wage-price spiral. In the extreme, this process can increase the risk of deflation, a damaging economic condition in which prices fall over time rather than rise.
Another reason that the Fed worries about low inflation expectations is that they are closely related to interest rates. When setting prices on loans, lenders and investors account for the expected rate of inflation over the life of the loan.
Nominal interest rates are the sum of the real interest rate that will be earned by lenders and the expected rate of inflation. They reduce inflation persistence and curb harmful macroeconomic volatility. However, persistently low inflation since the great financial crisis has led some central bank observers, and financial market participants in particular, to question the ability of central banks to deliver on their mandate.
In the euro area, where the coordinating role of a nominal anchor is particularly important in view of cross-country differences in wage and price-setting, market-based long-term inflation expectations have fallen since the crisis, and this fall has accelerated since the start of the year.
The second question is whether similar shifts in the expected inflation outlook can be observed in the wider economy — that is, whether, and to what extent, market-based inflation expectations affect actual inflation outcomes and can become self-fulfilling by unleashing perilous second-round effects. While there is no room for complacency, I would argue that there are three arguments that provide some ground for comfort. The first is that the drop in long-term market-based inflation expectations has been a global phenomenon, including jurisdictions where policy rates are currently well above the zero lower bound.
This suggests that concerns by market participants likely extend well beyond the realm of monetary policy. The third argument relates to the precise anatomy of the decline in market-based inflation expectations. ECB staff analysis suggests that market-based expectations are much more in line with survey-based inflation expectations once one corrects for the inflation risk premium — that is, the compensation investors demand for bearing risks related to the uncertainty around the future inflation path.
You can see this on the left-hand side of my first slide, which shows a breakdown of inflation-linked swap rates into expected inflation and an inflation risk premium. Actual expectations have fallen to a much smaller extent. In other words, while expectations of a surge in euro area demand and inflation, as typically captured by a rising inflation risk premium, have been significantly cut, expectations about the baseline have remained more stable.
Yet, while shifts in risk premia can explain the bulk of recent developments in long-term inflation expectations, they can explain much less of the recent fall in short and medium-term expectations, which you can see on the right-hand side of this slide. Three-quarters or more of the decline in short and medium-term maturity inflation swap rates since the autumn of last year reflect a genuine fall in inflation expectations.
Such a drop in short and medium-term inflation expectations is particularly remarkable in an environment where highly volatile inflation components, such as energy prices, have remained relatively stable, and have even been rising since the start of the year.
Recent market developments therefore suggest expectations that the current weakness in euro area and global demand will persist. This brings me to the second question as to whether similar shifts in the expected inflation outlook can be observed outside financial markets.
One drawback of much of the empirical work on the role of inflation expectations is that it has largely assumed that all measures of expectations are interchangeable — that households and firms can be assumed to have expectations akin to those of professional forecasters or financial market participants. In reality, reliable data on inflation expectations of consumers or firms are scarce. Yet, there is convincing evidence that, although households may not be able to correctly identify the current level of inflation, they have a fairly good understanding of changes in the trend of current inflation, and that these changes are likely to inform their expectations about future inflation.
What you can see here is actual HICP inflation together with qualitative consumer inflation expectations for the following year, computed as a balance statistic which is the difference between the share of respondents who expect prices to rise and the share of those who expect prices to fall, or to stay about the same.
Much of this correlation is typically driven by price developments in some of the goods and services that consumers purchase more frequently. To put it simply, if goods are purchased more regularly, price changes are more likely to be noticed. You can see this on the left-hand side of my next slide, which relates household inflation expectations to annual inflation in energy and unprocessed food — products for which most consumers typically have a good understanding of price developments.
Clearly, the correlation is much closer than when these two product categories are excluded, as you can see on the right-hand side. You can see this on my next slide. Changes in the direction of household inflation expectations are typically very similar to those of professional forecasters, which are shown on the left-hand side, and financial market participants, which are shown on the right-hand side, at least for horizons of up to one or two years.
In other words, most individuals — whether financial investors, teachers or nurses — use simple rules of thumb to form their short-term inflation expectations. And current inflation seems to be the most widely used heuristic in this respect, making some degree of inflation persistence a natural and inevitable phenomenon. Developments over the past year, however, mark a clear and visible departure from past regularities.
As you can see on the right-hand chart, a growing gap has emerged between the inflation expectations of market participants on the one side, and households and professional forecasters on the other. This is not about differences in the level, which — as I have argued before — may not mean much. This is about different dynamics, with the two-year moving correlation between market-based and household expectations dropping from 0. So, unlike the situation in late and early , when inflation expectations fell sharply across the population, and when we launched the asset purchase programme, today households are much less sceptical about the future.
The first is what happens to inflation if financial market participants and households hold diverging views on the future direction of inflation. The second question is why we are seeing this divergence in views, and whether it is temporary or likely to persist.
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