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Great Expectations: What Inflation Indexes Can Tell Us about the Future

inflation graphicYour high school students most likely have a long list of expectations that they have set for themselves and that others have set for them. They might feel pressured by these expectations to achieve an A on an assignment or to get into a certain college, to play a perfect game or to have a flawless music performance. Expectations can ultimately influence the final product of students' work. Expectations also play a critical role for monetary policymakers. When developing and implementing policy, policymakers usually consider the public's expectations regarding how quickly prices will rise.

Sticky prices
One tool that the Federal Reserve uses to gauge inflation expectations is the Atlanta Fed's sticky price index, calculated using components of the consumer price index (CPI). A sticky price, true to its name, is one that changes relatively infrequently. There are many reasons why a price may be slow to change, but the cost to businesses of updating prices, known as "menu costs," is one common cause. It costs money for shops to reprint price tags or for restaurants to laminate new menus with updated prices. Some prices may also be slow to change because they are set in a contractual arrangement—rental prices, for example. When businesses adjust sticky prices, the changes tend to incorporate their expectations about the inflation rate over the intervening period between that price change and the next. For example, coin-operated laundromats change their prices, on average, approximately every six years. So when a laundromat operator changes the price of washing a load of laundry—a sticky-price component of the CPI—the operator must think about how much he or she expects prices of similar services to increase over that period to avoid having to update the price again during those six years.

Of course, not all sticky prices change over such a long horizon. The median frequency of price changes for components of the CPI is about 4.3 months. Prices that change more frequently are considered "flexible," and prices that change less often are considered "sticky." Roughly 60 percent of the components of the CPI can be considered sticky price goods.

Falling prices
In addition to looking at sticky prices, it is also important to monitor the likelihood of deflation, or a falling price level. In a November 2010 article in the Washington Post, Ben Bernanke, chairman of the Federal Reserve, noted that very low inflation can morph into deflation, which can in turn contribute to a long period of economic stagnation. Falling wages and prices result in more economic slack, or underutilization of capital and labor. "When the economy is operating with slack, production costs tend to rise more slowly and firms have less scope for raising prices," notes a report from the Federal Reserve Bank of New York. The Great Depression of the early 1930s is a good example of the hardship that deflation creates for individuals and families. Falling prices during this period contributed to falling output and rising unemployment.

Every Thursday, Atlanta Fed economists publish an estimate of the five-year deflation probability of the CPI using treasury inflation-protected securities (TIPS). To estimate deflation, they use price differences between a 10-year TIPS issued about five years ago and a recently issued 5-year TIPS. Part of the price difference between the 10-year and 5-year TIPS issues tends to reflect the value of the better deflation safeguard of the latter security. (See this macroblog post for a more detailed explanation.)

With negative inflation, the real interest rate increases. This is because the so-called Fisher equation, i=r+ π—where r is the real interest rate, i is the nominal interest rate, and π is inflation—can be rewritten as r = i – π. Higher real interest rates result in lower investment and output growth. Expansionary monetary policy may therefore follow periods of low inflation or deflation in order to lower the real interest rate.

Businesses' expectations
The business inflation expectations (BIE) survey, conducted by the Atlanta Fed and established in October 2011, allows economists to examine the amount of slack in the economy. The online survey polls a panel of 300 southeastern business leaders each month about their inflation expectations for the short and long term. The survey asks questions about year-ahead cost expectations and factors influencing price changes, such as labor costs, sales levels, and productivity. It also incorporates "special questions" that are of longer-term interest for researchers. The survey is unique in that it goes straight to businesses, the price setters, rather than to consumers or households, to understand their expectations of the price level. Many of the businesses have national and international markets, so they represent an array of price setters, according to economists at the Atlanta Fed. It also tries to determine factors that drive cost changes and inflation uncertainty. "We would like insight into the process of how businesses form their inflation expectations," said Mike Bryan, vice president and senior economist at the Federal Reserve Bank of Atlanta. Bryan's research focus includes inflation.

Businesses in the panel vary by size, industry, and location, and this breadth and depth mean that economists can analyze the data in a variety of ways. For example, the special question on the April 2013 survey asked respondents to assign a percent likelihood to various changes in unit sales levels over the next 12 months. Researchers categorized the data by industries, including construction and real estate, finance and insurance, and manufacturing. This breakdown made it easy for them to see how industries differed in their response: general services expected unit sales to grow by 2.2 percent while finance and insurance expected growth of only 1.3 percent.

How does the Federal Reserve respond to a shift in expectations?
Any central bank with a mandate to keep the price level stable must address a shift in inflation expectations, whether that shift is an expected increase or decrease in the price level. The importance of considering inflation expectations is clear when looking at statements released by the Federal Open Market Committee (FOMC), the Federal Reserve's monetary policymaking body.

It is important to keep in mind that monetary policymakers do not rely on only one inflation indicator. They look at many inflation indexes because they want to judge how broad-based the "inflationary signal" is, according to the Atlanta Fed's Bryan.

After its meetings, which occur roughly every six weeks, the FOMC releases statements that acknowledge the stance of inflation expectations. There is often a clause that states that "longer-term inflation expectations have remained stable," but when this is not the case, the central bank may take action by adjusting monetary policy.

For example, in the fourth quarter of 2010, the Federal Reserve began the second round of quantitative easing (or QE2) in response to a change in inflation expectations. During this time, both the sticky price index and deflation probabilities indicated low and falling inflation. Interestingly, the CPI for all items actually rose 1.5 percent (the CPI minus food and energy rose by 0.8 percent), according to the U.S. Bureau of Labor Statistics. In this instance, policymakers felt that the CPI was not the best measure of inflation. They bought $600 billion in long-term Treasuries in an effort to lower interest rates and spur economic activity.

The Federal Reserve aims for 2 percent inflation over the medium term, so policymakers may need to act when expectations change. Just as students often change their behavior in response to others' evolving expectations, policymakers may need to respond to market evaluations of the trajectory of prices in order to implement optimal policy.

Questions for the classroom

  1. What are sticky prices, and how can they help us to understand inflation expectations?
  2. Why are certain prices sticky?
  3. What were the consequences of deflation around the time of the Great Depression?
  4. How does deflation affect the real interest rate and thus investment and overall economic output?
  5. What does "economic slack" mean for the economy?
  6. How does the Federal Reserve use monetary policy in response to changing inflation expectations?

Related links
The Inflation Project
Classroom Economist
The Fed Explains Inflation video
Extra Credit article on inflation indexes
macroblog on inflation

By Elizabeth Bruml, an economics major at Emory University in Atlanta, who contributed this article as part of her internship at the Federal Reserve Bank of Atlanta

August 26, 2013