What is Inflation Expectations?
Inflation Expectations refer to the opinion on the future rate of inflation from different sections of the society including investors, bankers, central banks, workers, business people. Thus they go on to consider this rate while basing their decisions with regard to various economic activities that they would like to undertake in the future.
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 undertakes a survey of consumer expectations every year ever since the year 2013 of June
- It is done through a nationally representative body of a rotating panel of around 1300 household heads
- It is undertaken for a period of 12 months with the panel consisting of an equal number rotating in and out on a frequent basis
- It revolves around economic outcomes relating to that of 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 goes on to track the age, education, income, house ownership status, employment history, etc. of 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 that your family is better off than what they were 12 months ago
- Do you think your family will be better off in the next 12 months
- What do you think will be the interest on SB accounts 12 years from now
- Do you think the stock prices will be higher than that they are now
- Over the next few months do you think that there will be inflation or deflation?
- What do you expect the rate of inflation to be in the next 12 months
- What 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 go on to closely track the economy as a whole.
The SPF would provide certain forecasts of the 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 also on that of the personal consumption expenditures price index (PCE).
#2 – Market-Based Method
Under this method, the gauge of inflation in the economy is done through 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 principal amount of the bond in par with inflation. This method goes on to understand the price difference between the Treasury note and the real inflation-protected security that trade in the market.
For example, If one were to consider yield on a 10 year bond of a country is 4.5% and then the yield on the same country’s 10-year inflation-protected bongoes on to be 2.5%, we can thus infer that the market is currently pricing in a 4.5% – 2.5% = 2% average annual inflation over that of the upcoming next 10 years
The method of TIPS can be considered as informative as it tends to react more to all of the incoming information.
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For eg:
Source: Inflation Expectations (wallstreetmojo.com)
Advantages
- Business decision making: Businesses take into account the expected rate of inflationRate Of InflationThe rate of inflation formula helps understand how much the price of goods and services in an economy has increased in a year. It is calculated by dividing the difference between two Consumer Price Indexes(CPI) by previous CPI and multiplying it by 100.read more to make certain decisions with regard to firm pricing and also negotiating certain contracts or even when it comes to wage negotiations. They may make certain changes in their products be it in terms of quantity or price to accommodate the expected rise in prices in the future, brought in by inflation.
- Household decision making: By factoring the necessary increase in prices of all essential household goods, groceries and consumption materials, the households will rationally decide the upcoming budget and try to save money into wealth enhancing avenues such as the stock market to ensure inflation does not erode the real value of money with time.
- Inflation targeting by central banks: By being able to gauge the necessary sentiment and expectations of the households and business, the central banks may be able to stir the economy by adopting the required expansionary/contractionary monetary policies to target the inflation as per the set framework
Limitations
- Time-consuming: The survey method of inflation which is to be undertaken by interviewing several households and is often a very time-consuming affair and certainly demands laborious efforts from the research team
- Deviations from actual: More often than not it is often noticed that 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 certainly expect it and thus build those expectations into their actions.
- This collective reaction on their side, in turn, creates sort an inflationary momentum of its own. Such kind of expectations would give inflation more of a self-sustaining character and would then cause it to persist in the economy even after the initial cause has disappeared
Conclusion
Inflation expectations certainly have its own advantages as it factors 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 sections of the economy.
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