Most measures of inflation expectations remain at a level consistent with the Fed’s 2% flexible average inflation targeting (FAIT) framework
In recent months, core PCE inflation accelerated sharply. However, policymakers have so far maintained their long-held view that the recent acceleration will be transitory, pointing specifically to well-anchored inflation expectations. There are many indicators to gauge inflation expectations, each with its limits. Against this backdrop, the Fed staff developed the quarterly index of common inflation expectations (CIE). Although the CIE is a helpful way of summarizing various expectation measures, the quarterly frequency is a notable drawback. As a result, we estimate a similar model to replicate the index with available data. We estimate that the CIE will increase moderately 4bp to 2.05% in Q2, up from 2.01% in Q1. Although the recent rebound has been a bit faster than we had previously expected, 2.05% would remain below the levels that prevailed prior to 2014, when inflation expectations started trending lower. Despite some divergence among major inflation expectations measures, we think inflation expectations are now closer to the center of the range consistent with the Fed’s inflation mandate after remaining at the bottom of that range in recent years.
Although we judge that policymakers are comfortable with current levels of inflation expectations (see discussion of individual indicators below), the Fed’s reaction function to higher inflation expectations is an important input when considering removing monetary accommodation. Past remarks by Fed officials suggest the Fed believed long-term inflation expectations were too low as of early 2016. In our view, this suggests the Fed would only consider accelerating the process to remove monetary accommodation if the CIE exceeds 2.10%, the level that prevailed until 2013, and remained elevated for a couple of quarters. Importantly, most inflation expectation indicators have not reached a point where inflation risks would lead to the Fed’s pivot to reduce monetary accommodation aggressively.
Inflation expectations across consumers, professional forecasters/economists and market-based measures are all important inputs for the CIE. However, we judge that these metrics remain at a level consistent with the Fed’s 2% flexible average inflation targeting framework.
Senior US Economist
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