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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
horizons indicates that market participants view the impact
objective. Put another way, fluctuations in oil prices and other nonof
in oil prices on inflation as largely transitory. Appar monetary phenomena will have less impact on the public’s longently,
has remained convinced that the Federal Reserve
run inflation forecasts the more strongly the public sees policyis
keeping inflation low. If measures of long-term
makers as being committed to a particular inflation objective.
were to rise significantly, it would reflect less
To gauge inflation expectations, analysts typically look to either
than it would about the credibility of the
surveys or market measures, such as the difference in yields on
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
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
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
$ Per Barrel
the price of oil from over $74 per barrel in July
to less than $60 per barrel in October.
5-Year Forward TIPS Spread
(left scale)
Although measures of near-term expected
inflation, such as the 5-year TIPS spread, have
moved closely with energy prices, measures of
expected inflation over longer horizons have been
less sensitive to fluctuations in energy prices. For
example, the 5-year forward TIPS spread, which
5-Year TIPS Spread
reflects expected inflation over the 5-year period
(left scale)
beginning 5 years in the future, has been less
Oil Price (right scale)
closely correlated with fluctuations in oil prices
than the TIPS spread covering the current 5-year
period.2 The 5-year forward TIPS spread, which
is also shown in the chart, has ranged between
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


Views expressed do not necessarily reflect official positions of the Federal Reserve System.