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.

One needs to remember that there are differences between inflation compensation and inflation expectations. In particular, the inflation compensation measures reflect not only investors’ expectations about inflation but also the amount they are willing to pay in order to protect themselves from inflation risk. In addition, the TIPS market is less liquid than the Treasury market, so there is a liquidity premium in inflation breakeven and compensation rates. We should expect the inflation risk premium and the liquidity premium to vary over time, so one needs to use a model to extract a measure of inflation expectations from inflation compensation. These models can produce very different estimates of the components depending on circumstances. For example, Figure 8 shows the inflation risk premia based on models maintained by the Cleveland Fed staff and the San Francisco Fed staff. You’ll note that even the signs can differ: in the most recent period, the San Francisco Fed model is estimating a negative risk premium while the Cleveland Fed model is estimating a positive risk premium. So the inflation expectations derived from these models can be quite different, as shown in Figure 9. In addition, at times, demand for Treasuries can increase significantly as investors seek safe haven flows for their money. This can make it even harder to infer inflation expectations from changes in inflation compensation. Finally, in the U.S., changes in the inflation compensation measures also seem to be correlated with changes in energy prices, a correlation that suggests they may not be reliable indicators of long-term inflation expectations.

Jon Faust and Jonathan Wright argue that market-based inflation compensation measures are too volatile to be plausible estimates of longer-term inflation expectations, and they show that the data reject the hypothesis that today’s five-year, five-year forward inflation compensation is a rational expectation of inflation in the long-run.

This means that one of the major benefits that were expected from the introduction of inflation-indexed bonds (Treasury Inflation-Protected Securities, generally called TIPS), namely that they would provide a quick and reliable measure of inflation expectations, has not been borne out, and that we still have to struggle to get reasonable estimates of expected inflation.

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.

Figures 2 and 3 showed that expectations for 2014 inflation have declined, and with inflation having consistently undershot the Federal Reserves 2 percent target, it is possible that longer-term inflation expectations are starting to decline as well. Figure 6 provides one way to capture longer-run inflation expectations. By subtracting the 10-year inflation-indexed Treasury yield (TIPS) from the 10-year Treasury yield, you get a measure of so-called break-even inflation. That is, this difference represents the prevailing inflation rate that should make you indifferent between holding a fixed-rate bond and holding a Treasury bond of the same maturity that floats with the inflation rate. The latest readings have been at the low end of recent experience. However, one must be cautious to infer too much from Treasury interest rates, particularly given the recent volatility and the flight to quality by many global investors that may have temporarily reduced Treasury yields.

Market-based measures of longer-term inflation expectations have fallen recently to unusually low levels, a decline that I believe reflects that kind of increased downside risk.

There are a number of possible actions that I would have seen as responsive to the evolution of the data. Let me describe two in particular. First, the Committee could have continued to buy $15 billion of longer-term assets per month. Second, it could have committed to keeping the target range for the federal funds rate at its current level at least until the one- to two-year-ahead inflation outlook has risen back to 2 percent, as long as risks to financial stability remain well-contained. These actions would have put upward pressure on the demand for goods and services and on prices. Just as importantly, these actions would have communicated that the Committee is determined to do what it takes to push inflation back to 2 percent as rapidly as is possible.

Some fear inflation expectations are on the move in reaction to recent experience. As suggested a moment ago, I don't hold that view. But I feel that it's important to acknowledge that not enough is known about transitional periods from one state of expectations to another. Even though we're measuring expectations, there's an element of looking back to gauge their essence. I do not dismiss the view that we run the risk that by the time change in expectations is clear, it's too late. In my view, we need to know more about how and why inflation expectations shift.

That said, years of hard work by economists have gone into developing the measures of inflation expectations we currently track. And I have challenged our Atlanta Fed research staff to build on this progress.

As for inflation compensation derived from spreads between yields on nominal and inflation-indexed Treasury securities (known as Treasury Inflation-Protected Securities, or TIPS), the implied rate of inflation compensation from five years ahead to ten years ahead (the so-called five-to-ten-year-forward rate) has risen somewhat since the beginning of the year.  Does this rise in forward inflation compensation indicate that long-run inflation expectations have risen by a similar amount?  My best guess is that much of the rise in inflation compensation reflects other factors.

To begin, recall that inflation compensation measured by using TIPS yields is not the same thing as inflation expectations.  Rather, movements in inflation compensation reflect not only changes in inflation expectations, but also changes in an inflation risk premium and in the relative liquidity of TIPS and similar maturity nominal Treasuries.  To see that these components are distinct, recall that during the period of heightened concerns about deflation in 2003 and 2004, forward inflation compensation rose substantially to an unusually high level amid concerns about an unwelcome fall in inflation; that earlier episode, in particular, underscores the fact that we must be careful in using the forward rates of inflation compensation as a gauge of long-run inflation expectations. 

I take the TIPS spread or the steepening of the yield curve as an indicator of market sentiment, market belief.  But I don't think any single indicator is definitive.

From the Q&A session, as reported by Bloomberg News

Although inflation compensation over the next five years, as measured in Treasury markets, has been essentially unchanged recently, longer-run inflation compensation rose modestly, along with the rise in long-term rates that I discussed earlier. My guess is that this increase largely reflects an elevation in inflation risk premiums or the influence of some idiosyncratic factors affecting the demand for Treasury debt, rather than an increase in long-run inflation expectations. I base this conclusion on the fact that longer-run inflation compensation also ticked up in the United Kingdom, a country where inflation expectations have been remarkably well anchored over the past decade and where inflation has been trending downward. The fact that longer-run inflation compensation rose in both countries, despite their different monetary policy regimes, suggests that a common explanation is needed, rather than one specific to the U.S. This result suggests that inflation expectations in the U.S. continue to be well anchored as they have been for at least the past ten years or so, as the Fed has established its credibility with the public about both its commitment to and its competence in keeping inflation at low and stable rates.

[T]he data suggest to me that long-run inflation expectations are currently around 2 percent.  That said, I think it should be clear that the evidence points to a range of estimates; moreover, this range is itself uncertain because of the assumptions needed to tease point estimates from the available data.  So, although I think that 2 percent is a reasonable estimate of current long-run expectations, I don’t want to overstate the precision of this figure.  We still face some uncertainty in this regard, and policymakers must be cautious about placing too much confidence in any one estimate.  

The issue of expectations illustrates our ignorance.  As I have already indicated, inflation expectations are among the most important variables policymakers monitor, but we do not have answers to our most basic questions about them:  Are available measures suitable indicators of true inflation expectations by households and businesses?  How are expectations formed--and in particular what are the respective roles of central bank talk, central bank actions, and actual inflation outcomes?  And how do expectations influence price and wage setting?  In short, although I believe that inflation expectations are critical to assessing the inflation outlook, I cannot be sure (particularly in real time) that our expectational measures are accurate and so cannot know what precise role expectations play in wage and price dynamics.  

The Report does not say that inflation expectations are unimportant to the determination of inflation — their calibration exercise argues exactly the opposite, in fact — only that our available measures provide imperfect indicators. The stability of expectations measures, the authors argue, might mask potential instability in actual inflation expectations. With this I wholeheartedly agree; as I noted a moment ago, one can see measures of inflation expectations as in some sense "anchored" without being either satisfied with where they are anchored or sanguine about their stability.

Measures of inflation compensation derived from nominal and indexed Treasury yields provide information that addresses some of the weaknesses in survey measures... Even here, however, we encounter important technical difficulties:  These inflation compensation measures are "contaminated" both by an inflation risk premium and by differences in liquidity between the markets for nominal and indexed Treasury securities.  More fundamentally, even a "rational" forecast of inflation from financial markets provides only part of the information needed to form monetary policy because it gives only a sense of where inflation is expected to go, not why it is going there.  The latter question is often important for assessing the appropriate stance of policy.

If you condition monetary policy strictly on expectations you're going to get a hall of mirrors problem, and it's not a good idea, to put it mildly...

We do look at expectations.  We think it's informative in a number of ways.  But we certainly don't substitute expectations data for more fundamental analysis of inflation. 

From the Q&A session.