Inflation expectations and economic outcomes
How did inflation and inflation expectations change during the COVID-19 pandemic?
Source: 15north
Inflation this year is the highest that it’s been in the last four decades. And bringing it back under control is the Federal Reserve’s topmost priority.
But it may take more than increasing interest rates to lower inflation. People need to believe that it will come down too. As Federal Reserve Chair Jerome Powell remarked in 2019, “inflation expectations are the most important driver in actual inflation.”
In a paper in the Journal of Economic Perspectives, authors Carola Binder and Rupal Kamdar explore the relationship between realized and expected inflation, examining key historic periods of inflation in the United States, including the COVID-19 pandemic.
Figure 4 from their paper shows how inflation and expected inflation has evolved since 2019.
Figure 4 from Binder and Kamdar (2022)
In both panels, the first vertical red line, at March 2020, marks when COVID-19 was declared a pandemic and the second vertical red line, at August 2020, marks when the Federal Reserve adopted “average inflation targeting,” which may have affected inflation expectations.
Panel A plots the Consumer Price Index (CPI) and the “Covid CPI”—a measure of inflation that captures new spending patterns caused by the pandemic. The chart shows that during the first year of the pandemic, the Covid CPI was higher than the CPI, indicating that consumers were experiencing inflation at a higher rate than the official measure would suggest. Inflation has since increased significantly according to both indicators.
Panel B plots measures of consumer inflation expectations from the Michigan Survey over one- and five-year horizons, professional forecaster inflation expectations from the Survey of Professional Forecasters over the ten-year horizon, and market-implied inflation expectations imputed from Treasury Inflation Protected Securities for a ten-year horizon. This panel reveals that consumer inflation expectations didn’t decline over the initial stages of the pandemic like the other sources did.
The authors explore the reasons behind these fluctuations and the disconnect between consumer, market, and professional forecasts of inflation, stressing the importance of understanding long-run inflation expectations and the array of differences in those expectations.
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“Expected and Realized Inflation in Historical Perspective” appears in the Summer 2022 issue of the Journal of Economic Perspectives.