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Economic SYNOPSES short essays and reports on the economic issues of the day 2007 ■ Number 3 Expected Inflation Near and Far David C. Wheelock luctuations in the price of oil and other apparently noninflation over long horizons, such as the Survey of Professional Forecasters by the Federal Reserve Bank of Philadelphia, have monetary phenomena often seem to drive the near-term been even more stable. The median 10-year average CPI inflaoutlook for inflation. Nonetheless, economists widely accept tion forecast from the Survey of Professional Forecasters has the view that, over the long run, inflation is determined by monebeen within 0.10 percentage points of 2.5 percent since 1999.3 tary policy. Thus, at longer horizons, expected inflation primarily The relative stability of measures of expected inflation over reflects the public’s view of the monetary policymaker’s inflation longer horizons indicates that market participants view the impact objective. Put another way, fluctuations in oil prices and other nonof fluctuations in oil prices on inflation as largely transitory. Appar monetary phenomena will have less impact on the public’s longently, the public has remained convinced that the Federal Reserve run inflation forecasts the more strongly the public sees policyis committed to keeping inflation low. If measures of long-term makers as being committed to a particular inflation objective. expected inflation were to rise significantly, it would reflect less To gauge inflation expectations, analysts typically look to either about the price of oil than it would about the credibility of the surveys or market measures, such as the difference in yields on Federal Reserve’s commitment to holding inflation in check. ■ ordinary Treasury securities and inflation-protected Treasury 1 An increase could also reflect an increase in inflation-risk premiums. For a securities (TIPS) of similar maturity. An increase in the yields discussion of the use of the TIPS yield spread as a measure of expected inflation, on ordinary securities relative to those on TIPS would suggest see Kevin L. Kliesen and Frank A. Schmid, “Monetary Policy Actions, that market participants have raised their forecast for inflation Macroeconomic Data Releases, and Inflation Expectations,” Federal Reserve 1 over the life of the securities. Bank of St. Louis Review, May/June 2004, 86(3), pp. 9-21. The chart plots monthly observations on the 5-year TIPS 2 The 5-year forward TIPS spread is obtained by dividing the total inflation spread from January 2004 through November 2006. The spread expected over the entire 10 years [(1 + 10-Yr TIPS Spread)10] by the total inflation expected over the first 5 years [(1 + 5-Yr TIPS Spread)5] and then taking this ratio’s fluctuated widely in 2004 and 2005, reflecting both volatility in 5th root (equivalent to raising it to the 0.2 power) to get the average annual rate. oil prices and uncertainty about the economic outlook following 3 See www.philadelphiafed.org/econ/spf/index.html. hurricanes Katrina and Rita. More recent changes in the spread have also closely coincided with fluctuations in energy prices. A sharp TIPS Spreads and the Price of Oil decline in the spread in the second half of 2006, for example, coincided with a large decline in Percent $ Per Barrel the price of oil from over $74 per barrel in July 3 to less than $60 per barrel in October. 5-Year Forward TIPS Spread 75 (left scale) Although measures of near-term expected 2.75 inflation, such as the 5-year TIPS spread, have 65 moved closely with energy prices, measures of 2.5 expected inflation over longer horizons have been less sensitive to fluctuations in energy prices. For 55 2.25 example, the 5-year forward TIPS spread, which 5-Year TIPS Spread reflects expected inflation over the 5-year period (left scale) 45 beginning 5 years in the future, has been less 2 Oil Price (right scale) closely correlated with fluctuations in oil prices than the TIPS spread covering the current 5-year 35 1.75 period.2 The 5-year forward TIPS spread, which is also shown in the chart, has ranged between 1.5 25 2.25 and 2.75 percent since 2004 and declined Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov only modestly with the fall in oil prices in the 05 05 05 05 05 06 06 06 04 04 04 04 04 04 05 06 06 06 second half of 2006. Survey measures of expected F Views expressed do not necessarily reflect official positions of the Federal Reserve System. research.stlouisfed.org