We measure inflation expectations through surveys of forecasters and the general public, and also through market readings on inflation swaps and "breakevens," which represent inflation compensation as measured by the difference between the return offered by nominal Treasury securities and that offered by TIPS. Since mid-2014, these market-based measures have declined significantly to historically low levels. Some of this decline probably represents lower risk of high inflation, or an elevated liquidity preference for much more heavily traded nominal Treasury securities, rather than expectations of lower inflation. Some survey measures of inflation expectations have also trended down. Given the importance of expectations for determining inflation, these developments deserve, and receive, careful attention. While inflation expectations seem to me to remain reasonably well anchored, it is essential that they remain so. The only way to assure that anchoring is to achieve actual inflation of 2 percent, and I am strongly committed to that objective.

It's very hard to know exactly what inflation expectations are relevant to actual price and wage decisions. And so, for example, we have seen the Michigan survey, a measure of household inflation expectations, move down. That's a preliminary number. It's hard to know what to make of it. We've certainly take note of it.

Inflation expectations measures have bounced back –with energy prices they have bounced back, but they’re still relatively low compared to where they were in the middle of 2014, before oil prices started declining. So I kind of thought, if you wanted to see some numbers that you thought were kind of satisfactory measures of TIPS-based inflation compensation, I think summer of 2014 was the last time that we saw that. And then it had gone down, down, down, down, down, and now they’re come back up. But they really have not come back up to the previous level. So I think they’re still pretty low.

The last time – these talks I was giving in Asia, I was using this number that the 10-year TIPS inflation compensation, you know, was on the order of 1.6 (percent), but then you have to subtract 30 basis points off that to get to the PCE inflation expectation. So it’s only like 1.3 (percent) over the next 10 years. So that’s a pretty low – pretty low inflation expectation. And then – you know, and that’s without subtracting any kind of liquidity premium or risk premium or anything like that.

So I would say that they’re too low. And I’m one that has put more emphasis on that argument, probably, than others on the Committee. Others will cite survey measures. The Committee will often put survey-based things in the statement. I don’t think the survey-based measures move around in a way that is responsive to economic conditions. It’s just kind of like – (chuckles) – you ask people, they give you the same number month after month. So…

Individuals might act according to their subjective beliefs without being able to fully articulate in standard forms their underlying probability distribution. Thus, a need arises to elicit these views in order to understand behavior more fully.

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From the results of our cognitive interviews and experimental surveys, we decided in the Survey of Consumer Expectations to elicit medium-term inflation expectations at the one-year two-year-forward horizon. For example, in this month’s edition of the SCE we ask respondents what they expect the rate of inflation to be “over the 12‐month period between May 2018 and May 2019.” Our testing suggests that respondents understand this format better than that of the 5-10 year Michigan question; consumers are better able to provide their expectations over a specific time period in the future, and there is little value in asking them about a longer time horizon. In addition, we believe that the one-year two-year-forward horizon adopted in the SCE is better suited to measure inflation expectations at the medium-term horizon that matters most for central bankers, since monetary policy is expected to exert its full effect within that time frame.

I have been concerned about inflation expectations. And when I talked in mid-February especially, you had the five year, five year forward TIPS inflation measures down below 1.5 percent. That got me, you know, kind of nervous and I — and I started to flag those.

Now, they have recovered probably back to December levels. And I find that comforting. But you’d actually like to see those numbers even somewhat higher than they are today. And because they reflect somehow the credibility of the Fed and its ability to hit a long run inflation target of 2 percent.
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The inflation themselves have been stronger. The year-over-year inflation numbers have been stronger, PC core at 1.7 percent. So it’s definitely coming up toward the 2 percent target just as the Committee predicted. So this is one of the cross-currents here. You’ve got slow growth, but you do seem to get inflation moving back toward target.

Inflation has been held down recently by two factors, the falling price of oil and the rising value of the dollar. But neither factor is likely to depress inflation indefinitely. After the price of oil bottoms out, I would expect to see headline inflation move significantly higher. And after the value of the dollar ultimately tops out, core inflation should move back toward 2 percent. Although recent declines in inflation compensation do give me some pause, I think the evidence indicates that inflation expectations (as opposed to inflation compensation) remain well-anchored. Therefore, I am reasonably confident that, barring subsequent shocks, inflation will move back to the FOMC’s 2 percent objective over the medium term.

An important concern about persistently low inflation is that it can lead to a fall in longer-term inflation expectations, making it much more difficult to achieve our inflation target. For the most part, longer-term inflation expectations appear to have remained reasonably stable, though there are some concerning signs. Longer-term inflation expectations of professional forecasters and primary dealers have held quite steady in recent years at levels consistent with the FOMC's target. However, households' inflation expectations appear to have moved down somewhat recently.

“My preferred interpretation is that risk and liquidity premia associated with inflation compensation are relatively small with low volatility,” he explained. “Hence, I interpret declines in TIPS spreads as reflecting mostly declines in inflation expectations.”

While it has a short history, I put more weight on the New York Fed’s survey because its methodology should be more robust in accurately assessing consumer inflation expectations. Compared to the more widely followed University of Michigan survey, for example, the New York Fed survey has several advantages. The sample size is larger, most of the people that are interviewed are the same each month, and the inflation expectations question is posed differently to focus the respondent’s attention on inflation rather than on prices. We believe that all these factors lead to a more reliable estimate of inflation expectations.

While central bankers typically “look through” oil price changes, “one circumstance where one may be more concerned is when inflation expectations themselves begin to change due to the changes in crude oil prices,” he said.

There are some downside risks to this forecast. We might see further declines in energy prices or greater appreciation of the dollar. In addition, undershooting our 2 percent inflation target for as long as we have invites the risk of the public beginning to expect persistently low inflation in the future. If this mindset becomes embedded in decisions regarding wages and prices, then getting inflation back to 2 percent will be that much more difficult. Here, I find it troubling that the compensation for prospective inflation built into a number of financial market asset prices has drifted down considerably over the past two years. More recently, some survey-based measures of inflation expectations, which had previously seemed unmovable, have also edged down. So to achieve our inflation target — and to provide a buffer against downside risks — it is appropriate that we follow a gradual path to policy normalization.

We do monitor inflation expectations very carefully. If we saw in a meaningful way that inflation expectations were either moving up in a way that made them seen unanchored, or down, that would be of concern.  And we have called attention to some slight downward movements and survey measures. We are watching that. But I still judge that inflation expectations are reasonably well anchored.

From November 2010 through July 201431 consecutive meetingsthe FOMC was in a position to state that longer-term inflation expectations remain stable. Because of the decline in market-based measures of longer-term inflation expectations in the past few months, the Committee has not been able to make this assertion in the past three FOMC statements.

Despite these facts, the FOMC communicated its intention after this weeks meeting to continue gradually removing monetary accommodation. In my assessment, the FOMCs failure to respond to weak inflation runs the risk of creating a harmful downward slide in inflation and longer-term inflation expectations of the kind that we have seen in Japan and Europe. I see this risk to the credibility of the inflation target as unacceptable, given how hard it would be for the FOMC to respond successfully if this eventuality did indeed materialize.

We refer to this in the statement as inflation compensation rather than inflation expectations.

The gap between the nominal yields on 10-year treasuries, for example, and tips have declined. That's inflation compensation. And five-year -- five-year forwards, as you said, have also declined.

That could reflect a change in inflation expectations, but it could also reflect changes -- changes in assessment of inflation risks, the risk premium that's necessary to compensate for inflation that might especially have fallen if the probabilities attached to very high inflation have come down.

And it can also reflect liquidity effects in markets, and for example, it's sometimes the case that when there is a flight to safety, that -- that flight tends to be concentrated in nominal treasuries and could also serve to compress that spread.

So I think the jury is out about exactly how to interpret that downward move in inflation compensation, and we indicated that we are monitoring inflation developments carefully.

In assessing inflation expectations, I currently put more weight on survey-based measures of inflation expectations as opposed to market-based measures. Survey-based measures have been generally stable, consistent with inflation expectations remaining well-anchored. However, market-based measures, such as those based on breakeven inflation derived from the difference between yields on nominal versus Treasury Inflation-Protected Securities (TIPS), have registered declines over the past few months, even on a 5-years forward basis. Research done by my staff suggests that much of this decline in market-based measures of inflation compensation reflects a fall in the inflation risk premiumthat is, what investors are willing to pay to protect themselves against inflation risk. Adjusting for the fall in the inflation risk premium, inflation expectations appear to have declined much less than implied by TIPS inflation breakeven measures.