What are Inflation Expectations?

How to Find Inflation Expectation?

There are usually 2 methods in place to find the expected inflation

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#1 – Survey Based Method

Central banks of many countries go on to ascertain the forward-looking expected inflation in the country by undertaking surveys that would enable them to adopt the right strategy, be it expansionary or conservative, for that matter.

Example:

For example, the Federal Bank of New York has undertaken a survey of consumer expectations every year ever since the year 2013 June.

  • It is done through a nationally representative body of a rotating panel of around 1300 household heads.It is undertaken for 12 months, with the panel consisting of an equal number rotating in and out frequently.It revolves around economic outcomes relating to the labor marketLabor MarketThe labour market, also known as the job market, is a well-studied market that operates on the supply and demand dynamics of people looking for work (workers) and organizations/people providing work (employers).read more, inflation, household finance, etc.The survey tracks the age, education, income, house ownership status, employment history, etc. that of the respondent.

Some of the questions undertaken as a part of the survey to gauge the sentiment and inflation expectations of the consumers are listed as under

  • Do you think your family is better off than 12 months ago?Do you think your family will be better off in the next 12 monthsWhat do you think will be the interest on SB accounts 12 years from nowDo you think the stock prices will be higher than that they are nowOver the next few months do you think there will be inflation or deflation?What do you expect the rate of inflation to be in the next 12 monthsWhat is the current employment situation?

Further, another example of the survey-based measure would be that of the Survey of Professional Forecasters (SPF), which tends to be a group that would closely track the economy as a whole. 

The SPF would provide specific forecasts of inflation based on the consumer price indexConsumer Price IndexThe Consumer Price Index (CPI) is a measure of the average price of a basket of regularly used consumer commodities compared to a base year. The CPI for the base year is 100, and this is the benchmark  point.read more (CPI) and the personal consumption expenditures price index (PCE).

#2 – Market-Based Method

Under this method, the gauge of inflation in the economy is done by understanding the TIPS (Treasury Inflated Protected SecuritiesTreasury Inflated Protected SecuritiesTreasury inflation-protected securities (TIPS) are inflation-indexed bonds issued by the US government. Since its principal is indexed to the US consumer price index, it provides a hedge to the inflation risk. With increasing inflation, TIPS’s principal values also rise, hedging the bond’s inflation risk.read more), which increases the bond’s principal amount on par with inflation. This method understands the price difference between the Treasury noteTreasury Note and the real inflation-protected security that trade in the market.

For example, If one were to consider the yield on a ten-year bond of a  country is 4.5%. Then the yield on the same country’s 10-year inflation-protected bongos is 2.5%. We can thus infer that the market is currently pricing in a 4.5% – 2.5% = 2% average annual inflation over the next ten years.

The TIPS method can be considered informative as it tends to react more to all of the incoming information.

Advantages

Limitations

  • Time-consuming: The survey method of inflation, which is to be undertaken by interviewing several households, is often a very time-consuming affair and certainly demands laborious efforts from the research team.Deviations from actual: More often than not, the expected inflation will deviate from the actual inflation in the economy.Self-sustaining character: Usually, it is noticed that once inflation goes on to become embedded in a country, the businesses, consumers, workers, and all of the economic actors of every kind will begin to expect it certainly and thus build those expectations into their actions.In turn, this collective reaction on their side creates sort of an inflationary momentum of its own. Such expectations would give inflation more of an autonomous character and cause it to persist in the economy even after the initial cause has disappeared.

Conclusion

Inflation expectations certainly have their advantages as it factors in the expectations of the various sectors of the economy, thereby enabling the decision-makers to adopt the right decisions in their respective roles, be it households, business, or even central banks. Inflation expectations thus serve as a precautionary measure to headwind the actions towards the desired results by factoring in the sentiment and opinions of different economic sections.

This has been a guide to what Inflation Expectations are and their definition. Here we will discuss the top 2 methods (survey and market based) to find the expected inflation and examples, advantages & disadvantages. You can learn more about economics from the following articles –

  • Inflationary GapCost-Push InflationDeflation vs DisinflationHyperinflation Examples