The Fed’s Inflation Expectations Game – Wall Street Journal

Nov. 22, 2015 12:56 p.m. ET

Federal Reserve policy makers expect inflation will eventually reach their target. But the expectations of other people could get in the way.

The Fed aims to get inflation to 2%, but it is hardly close. When the Commerce Department releases the central bank's preferred inflation measure Wednesday, it will likely show prices a fraction of a percentage point higher in October than a year ago. Economists polled by The Wall Street Journal estimate core prices, which exclude food and energy to better capture inflation's underlying trend, were up just 1.3% on the year.

One reason the Fed is on course to raise rates next month is it believes much of the weakness in even core inflation is transitory, reflecting the decline in import prices that have come with the dollar's strength and weakness overseas. The problem is that years of low inflation have begun eating into people's inflation expectations. And with the pressure on import prices likely to last a while, there could be further erosion.

The spread, or difference, between Treasury inflation-protected securities and Treasury notes suggests that investors expect the Labor Department's consumer-price index (which has been running hotter than the Commerce Department's inflation measure) to average just 1.3% over the next five years. The implied rate of inflation over the five years that start five years from now—long after the effects of falling oil prices, a rising dollar and overseas weakness should have dissipated—has fallen to 1.9% from 2.3% last November.

The Federal Reserve Bank of New York's monthly consumer survey for October showed that households expect inflation three years from now will average 2.8%. That is down from 3.4% when the survey started in June 2013. (It is above the Fed's target, but consumers tend to expect more inflation than they get.) Meanwhile, inflation expectations in the University of Michigan's long-running consumer survey are at record lows. So, too, are the inflation expectations of economists surveyed by the Federal Reserve Bank of Philadelphia.

The Fed thinks inflation expectations matter because they help determine what inflation does in the future. When inflation expectations are high, as they were after the shocks of the 1970s, even a relatively high unemployment rate is enough to send prices up too quickly. Now, there is a possibility inflation expectations have fallen to the point the Fed will need to tolerate a much lower unemployment rate than it thinks is best if it wants to reach its target.

For now, the Fed seems to be treating the decline in inflation expectations, like the low levels of inflation itself, as a temporary phenomenon. But if expectations continue to decline, it is going need to rethink its own expectations about how quickly it can raise rates.