On the Michigan Survey of Inflationary Expectations

Paul Krugman notes:

But no modern user of IS-LM forgets that the diagram must be drawn for a given expected rate of inflation, and that large changes in expected inflation can make a big difference. In fact, that’s precisely the insight that lies behind calls for a higher inflation target, so as to avoid hitting the zero lower bound! But my other reaction is, what are these inflation expectations you speak of? Oh, wait, I seem to remember — didn’t they come on 5 1/4 inch floppy disks? The fact is that we’ve had low, fairly stable inflation expectations for a generation now. I know that there are economists for whom it’s always 1978, who are constantly fearing — or, I suspect, in their innermost selves, hoping — for a return of the good old days when inflation was a constant threat. But in the world we’ve been living in this past quarter-century or more, inflation expectations haven’t moved much, and nominal interest rates have, in practice, been a pretty good guide to the stance of monetary policy.

My only issue with his post was his use of the Michigan survey as it suggests that inflationary expectations have been just over 3% for the past decade or so. While I understand why one would use this survey if one wanted to present a measure that covers the past 35 years, we do have market measures from January 2003 to today. Over this period, the Michigan survey measure has averaged 3.2%, while the difference between the nominal rate on 5-year government bonds and the real rate (as measured by the 5-year TIPS rate) has been only 2%. Andrea Pescatori and Timothy Bianco discussed alternative measures of inflationary expectations a few years ago:

Inflation expectations play a crucial role in monetary policy making. Not only do they tell policymakers something about the real expected cost of borrowing and hence the viability of investment plans, they also help policymakers gauge the public’s perception of the central bank’s commitment to maintaining a low and stable rate of inflation. Especially in the current policy environment, where the Fed has been forced by events to take unconventional actions, it is more important than ever to make sure that long-run inflation expectations are well anchored and that the policy message is well understood by the public.In principle, expectations are not observable. But there are at least two sources that can be used to infer them: surveys and market-based information.

In their discussion of the Michigan survey for 5-year forecasts, they note:

Given the longer horizon, we might be surprised to see that the recent median inflation expectation is quite stable around 3 percent, which is higher than the actual inflation comfort zone of 2 percent–2.5 percent described often by the Fed. In part, this might reflect a bias due to the fact that, when people think of the CPI, they put less emphasis on the prices of goods they buy less often, like durable goods. At the same time, the prices that have decreased the most in the last few decades have been exactly those for durable goods. Moreover, it is also true that the forecasts vary substantially, which may be in part because each individual consumer perceives inflation in terms of his or her own personal consumption bundle.

One of the reasons I bring this up relates to something else that Paul Krugman noted:

The alleged justification for chain-linking is that the conventional consumer price index overstates true inflation; it might overall, but probably not for seniors. In any case, however, as Matt points out, the very same Republicans who claim that Social Security benefits should be cut because the CPI overstates true inflation also insist that the Fed must stop quantitative easing, despite the absence of any visible inflation threat, because the real inflation rate is much higher than the official statistics indicate.

Since a lot of economists point to the market measures, which suggest inflation expectations are currently less than 2%, I’m surprise these Republicans who criticize the FED haven’t been screaming that the Michigan survey data indicates a higher expected inflation rate. Never mind that over the past 10.5 years, the average increase in the CPI has been only 2.36%. And remember that these same Republicans think this is some sort of overstatement.