Expected Inflation

Published Apr 28, 2024

Definition of Expected Inflation

Expected inflation refers to the rate at which people anticipate the general level of prices for goods and services will increase over a future period. It represents the average rate of inflation that consumers, businesses, and investors forecast for the coming year or several years ahead. Expected inflation is crucial because it influences various economic activities, including savings, investment decisions, wage negotiations, and pricing strategies.

Example

Imagine a scenario where consumers expect inflation to rise to 5% over the next year. As a result, workers might demand higher wages to maintain their purchasing power, and businesses may increase prices in anticipation of higher costs. This expectation can create a self-fulfilling prophecy where the anticipation of inflation contributes to actual inflationary pressures, as higher wages and prices fuel each other.

Similarly, if investors expect inflation, they may demand higher interest rates on bonds to compensate for the declining purchasing power of future interest payments and principal repayment. This can lead to increased borrowing costs for businesses and governments, potentially slowing down economic growth.

Why Expected Inflation Matters

Expected inflation plays a pivotal role in the economy by influencing both the microeconomic decisions of individuals and businesses and macroeconomic variables such as interest rates, wage growth, and monetary policy. Central banks, like the Federal Reserve in the United States, closely monitor inflation expectations to guide their monetary policy decisions. They aim to keep expected inflation within a target range to stabilize the economy.

If expectations of inflation are well-anchored at a low level, it can help maintain economic stability, as businesses and consumers have confidence that the purchasing power of money will not erode quickly. On the other hand, if inflation expectations rise significantly, it may become more challenging to control actual inflation, potentially leading to a vicious cycle of escalating prices and wages, known as an inflationary spiral.

Frequently Asked Questions (FAQ)

How are expectations of inflation measured?

Inflation expectations can be measured through surveys and market indicators. Surveys, such as the University of Michigan Survey of Consumers or the Survey of Professional Forecasters, ask participants directly about their inflation expectations for the near and medium-term future. Market indicators, like the difference between nominal and inflation-indexed bond yields (the break-even inflation rate), provide insights into investors’ expectations of future inflation.

What impact do expectations of inflation have on monetary policy?

Central banks adjust monetary policy in response to changes in inflation expectations. If expected inflation is above the central bank’s target, it might tighten monetary policy by raising interest rates to cool down the economy and bring inflation down. Conversely, if inflation expectations are below the target, it might ease monetary policy, lowering interest rates to stimulate spending, investment, and economic growth.

Can expected inflation differ from actual inflation?

Yes, expected inflation can and often does differ from actual inflation. This discrepancy can occur due to unexpected economic shocks, changes in oil prices, or shifts in fiscal policy. For example, if a sudden increase in oil prices occurs, it might lead to higher actual inflation than previously expected. Similarly, if a central bank successfully convinces the public it will keep inflation low, expectations may adjust downward, even if current inflation rates are high.

What are the consequences of unanchored inflation expectations?

Unanchored inflation expectations can lead to economic instability. If people begin to expect ever-higher levels of inflation without certainty, it can result in more volatile and unpredictable inflation rates. Businesses and consumers might overreact to price changes, exacerbating inflationary pressures. Central banks may find it challenging to manage inflation expectations once they become unanchored, requiring more aggressive monetary policy measures to stabilize the economy.

In sum, expected inflation is a critical concept in economics, influencing a wide range of economic decisions and outcomes. Understanding and managing inflation expectations are essential for promoting economic stability and growth.