The sharp rise in inflation in 2021 in many advanced economies was not anticipated to this extent by many households, professional economic analysts, or financial market participants. Whether this unexpected rise in inflation will translate into higher inflation rates in the coming years depends to a large extent on long-term inflation expectations. These have increased in the United States and the euro area, for example, in the course of 2021 and to some extent also following Russia’s invasion of Ukraine, but at least for the time being remain at levels that do not suggest any significant deviations from the two percent inflation targets in the United States and the euro area. In the U.S., for example, professional economic analysts’ expectations for annual inflation over the next ten years increased from 2.2% since the beginning of 2021 to 2.5% at the beginning of 2022 (figure), but did not indicate any significant increase in long-term inflation expectations; this is also reflected in the fact that between 2002 and 2021, the average of these expectations was 2.3%. It should be noted that here we are looking at the consumer price index published by the Bureau of Labor Statistics, which is more widely followed by the American public. For its average inflation target of two percent, the U.S. Federal Reserve prefers to observe the personal consumption expenditures index published by the Bureau of Economic Analysis, which usually indicates a lower inflation rate by about 0.3-0.6%.
Also, shortly before the start of the war in Ukraine, households surveyed in the University of Michigan’s consumer sentiment surveys still expected inflation to be 0.3 percentage point higher annually over the next five years than it was at the beginning of 2021. It should be noted that the inflation rates expected by households at the level usually overestimate actual inflation and in the past were also usually about half a percentage point higher than the expectations of professional economic analysts.
In addition to surveying professional economic analysts and households, another option is to look at securities-derived inflation expectations of financial market participants to identify changing long-term inflation expectations. One advantage of this approach is that these expectations respond without lags in each case and can be assumed to reflect the expectations of profit-oriented financial market participants. A significant drawback, however, is that in the past they have often turned out to be very volatile and usually somewhat too high compared with actual inflation, and they are also of limited use in identifying changes in inflation expectations among the population at large. It is noteworthy that in the U.S.A., inflation expected by financial markets increased only from 2.0% to 2.3% during 2021. Since Russia’s invasion of Ukraine, however, these expectations have become more volatile, fluctuating between 2.1 and 2.4%.
Similarly, for the euro area, it is possible to check whether long-term expectations are significantly above the European Central Bank’s two percent target. For example, according to the Survey of Monetary Analysts, inflation expectations are stable at two percent from2024 to 2028. In the Survey of Professional Forecasters, which is also conducted by the ECB, respondents also expect an average annual inflation rate of 2.0% until 2026. However, there is still a probability of around 20% that inflation will exceed 2.5% in this five-year period. By contrast, the probability that the inflation rate will be between 1.5% and 2.4% is estimated at just over 50%. After all, according to this survey, the probability of a long-term inflation rate of below 1.5% is just under 30%. On the financial markets, too, somewhat higher inflation rates are now expected for the euro area in the long term. In addition, surveys of households in Germany, for example, have revealed a slight increase in long-term inflation expectations since the end of 2021.
All in all, it can be seen that, although long-term inflation expectations have risen in the euro area as well, they are still within a range that is compatible with the inflation target. Although long-term inflation rates in the two major economic areas of the U.S. and the euro area are thus still within a largely unproblematic range, the increases since 2021, some of which have been noticeable, show that the expectations of the various economic players are nevertheless adapting to the current high inflation rates. For this reason, too, it seems crucial that central banks in advanced economies identify further inflation risks more clearly than they did last year, especially in view of the war in Ukraine and the sanctions against Russia.
Sources: University of Michigan, Consumer Sentiment Survey; Federal Reserve Bank of Philadelphia, Survey of Professional Forecasters; Federal Reserve Bank of St. Louis market-based inflation compensation using nominal and indexed Treasury securities.
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