Misunderstanding long-run inflation expectations

Inflation is far above central banks’ inflation targets in most countries. Some commentators are worried that it will remain much higher than the 2% average observed in many advanced economies since 2000. As evidence, they often note that measures of expected long-run inflation have risen above the levels of a few years ago.

For instance, the Michigan survey of inflation expectations shows that expected inflation over the next year rose from 2.5% in December 2020 to 5.4% in March 2022 as CPI inflation rose from 1.3% to 8.6%.¹ In the same period expected inflation over the coming 5 years rose from 2.5% to 3%, seemingly suggesting that on average future inflation would be 0.5% higher.

It should be noted that while the Michigan Survey presents the results as “expected change in prices during the next 5 years,” the question asked is in fact “about the outlook for prices over the next 5 to 10 years.” Thus, the forecast horizon is in fact uncertain. The results below are therefore calculated for both 5- and 10-year horizons.

Care is needed when interpreting the expected five-year inflation rate. To see this, consider Figure 1 below. The blue line shows that 1-year inflation expectations of 5.4% imply that prices are expected to rise from 100 to 105.4 over the next year. The orange line shows that since 5-year inflation expectations are 3%, over the next 5 years the price level is expected to rise to 115.² Importantly, the slope of the blue line depends on 1-year inflation expectations and the slope of the orange line depends on 5-year inflation expectations. 

Figure 1. Expected path of prices

Source: EFG calculations

But expected inflation over the next year is part of expected inflation over the next five years. That raises the questions of what is the expected inflation rate from years 2 to 5. That expected inflation rate is given by the slope of the grey line and is 2.4%.³ (Expected inflation from year 2 onwards in 2.7% if the forecast horizon is 10 years and 2.6% if the 7.5-year average of 5 and 10 years is used.)

The survey data on expected inflation for the next year and next five years can in this way be used to compute the expected inflation rate from year 2 onward, which is shown in Figure 2 together with the data on 1- and 5-year inflation expectations.

The graph shows that inflation expectations are front loaded: while expected inflation over the next year has risen sharply, expected inflation over the next 5, 7.5 or 10 years has not changed much. More importantly and as noted above, if the horizon is 5 years, the expected inflation rate has in fact fallen from 2.5% in December 2020 to 2.4% March 2022. (It has risen to 2.6% if a horizon of 7.5 years is assumed and to 2.7% if a horizon of 10 years is assumed.)

The main conclusion is clear: the change in longer-term inflation expectations reflects the pronounced changes in near-term inflation expectations. Expected inflation from year 2 onward has in fact been broadly constant in the period studied.

Figure 2. Inflation expectations

Source: EFG calculations on data as of 2 May 2022 from the Michigan survey.

¹ These expected inflation rates refer to the median (data as of 3 May 2022) and the inflation rates are calculated using data from FRED (data as of 30 April 2022).
² We treat the expected rate of inflation as continuously compounded. The algebra would be less clean if it was discretely compounded. The vertical axis should be interpreted as the logarithm of the price index.
³ The horizon for the “longer” inflation expectation is N, it can be computed as (N*3% - 5.4%)/(N-1) years.