I NFLATION EXPECTATIONS

We have argued throughout this paper that “management of expectations” is an important element in modern monetary policy. Also, many of the unconventional monetary policy measures that were described in section 4 work though effecting expectations. Credible commitment to low future interest rates should affect market participants‟ interest rate expectations and depress long term yields. We return to this subject in the next section. We have argued in section 4.2 that quantitative easing policies through increasing the money supply can have an impact on inflation expectations as money growth has historically been accompanied by inflationary pressures. Higher inflation expectations should depress the real rate of interest, which in turn should stimulate investment and the economy in general.

Even though it is important to prevent expectations of deflation, a sizeable increase in inflation expectations can have counterproductive effects. As discussed in the theoretical framework, the flexibility to stabilize the real economy requires that long run inflation expectations are “well anchored” among the agents in the economy. In particular, increased inflation expectations can increase the inflation risk associated with nominal bonds. This increase in risk premia will raise long term yields and counteract, for example, the commitment effect, where central banks pledge to hold their target rates low for an extended period of time.

Figure 20 and 21 plots one year inflation expectations in the USA and United Kingdom since the adaptation of quantitative easing policies. Inflation expectations are, of course, hard to measure reliably as they cannot be observed directly. Different methods and surveys have their advantages and disadvantages. Before interpreting the data, some words describing the selected surveys are in place.

We have chosen to include three surveys in the graph for USA: Livingston Survey, Survey of Professional Forecasters and University of Michigan Survey. For United Kingdom we were able to find two measures of inflation expectations: the NOP Survey conducted by the Bank of England and the YouGov/Citigroup Survey. Unfortunately, we were not able to find any measures for inflation expectations for Japan. A more detailed description of the surveys can be found in Appendix 1.

Figure 20 –Comparative analysis: Forecasts for the annual average rate of inflation over the next 12 months in the United States ³³

0 % 1 % 2 % 3 % 4 % 5 % 6 %

-12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12 14 16

USA - Michigan Survey USA - Survey of Professional Forecasters USA - Livigston Survey

Sources: Federal Reserve Bank of Philadelphia, University of Michigan

33 The x-axis is in monthly format. Quarterly and semi-annually surveys are transformed to months by keeping the level constant between survey dates.

Figure 21–Comparative analysis: Forecasts for the annual average rate of inflation over the next 12 months in the United Kingdom ³⁴

0 % 1 % 2 % 3 % 4 % 5 % 6 %

-12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12

UK - NOP Survey UK - YouGov/Citigroup Survey

Sources: Bank of England, Citigroup

In the US, the monthly Michigan consumer survey started to fall before the introduction of unconventional policies. The Livingston Survey that is conducted semi-annually and the Survey of Professional Forecasters that is conducted quarterly, both show a decline in December survey 2008. However, later surveys after the zero point show no significant decline. Annual inflation is still expected to be close to 2 percent in the US. In the UK both surveys started to fall before the zero point. The YouGov/Citigroup survey was even below one percent a few months before the start of quantitative easing. However, also in the UK short term inflation expectations have stabilized around 2 percent.

It appears that there currently is relatively little danger of deflationary expectations in the short run in these countries. This may indicate that the unconventional monetary policies at least prevented the short run inflation expectations from falling further.

Long term inflation expectations reflect to some extent the credibility of the central bank, and whether inflation expectations are well anchored within the public. The United Kingdom has implemented an explicit inflation targeting framework. Credibility of the policy can be

34 The x-axis is in monthly format. Quarterly surveys are transformed to months by keeping the level constant between survey dates.

evaluated by examining whether the public‟s inflation expectations remain anchored to the target. The US have not adopted such explicit frameworks, but still, stabile and low inflation expectations can be regarded as an essential aspect of monetary policy.

Figure 22 illustrates long run inflation expectations for the US and United Kingdom. For the US we have included observations since 1991, as this illustrates the downward trend in long run inflation expectations during the last two decades. The Citigroup survey in the United Kingdom has only been conducted since 2005, so no data is available prior to this. Similarly, the NOP survey has only included long run inflation forecasts since February 2009, so we only have 6 observations of the survey at the current date.

Figure 22 – Comparative analysis: Forecasts for the annual average rate of inflation over the next 5-10 years

0%

1%

2%

3%

4%

5%

-204 -192 -180 -168 -156 -144 -132 -120 -108 -96 -84 -72 -60 -48 -36 -24 -12 0 12 USA - Livingston Survey 10 years UK - NOP 5 years

USA - Survey of Professional Forecasters 10 years UK - Citigroup 5-10 years USA - Michigan Survey 5 years

Sources: Federal Reserve Bank of Philadelphia, University of Michigan, Citigroup

Figure 22 shows that long term inflation expectations have shown a steady downward trend since the early 1990‟s in the US. The forecasted average-annual 10-year growth rate for inflation has fallen from levels of approximately four percent in the 1990‟s to approximately

2.5 percent in 2010. The 5-year inflation expectations in the Michigan survey are slightly higher than the other surveys throughout the time period.

The downward trend in the long run inflation expectations since the 1990s probably reflects the fact that many central banks, including the Federal Reserve, have been successful in bringing down inflation during the last decades. Also, this development may reflect increased transparency in conducting monetary policy and more communication from monetary authorities.

Long term inflation expectations also show relatively little variability in the US during the last decade (-120 months), indicating that inflation expectations have been relatively well anchored among the American public. There is no observable sharp increase in the long run inflation expectations after Fed stopped sterilizing its open market operations. This suggests that public has not yet “lost faith” in the Fed‟s ability to control inflation in the future.

The YouGov/Citibank survey for the United Kingdom illustrates that longer term inflation expectations started to fall prior to the zero point, from levels of approximately 4 percent to just below 3 percent. More recently, they have climbed upwards again, and are currently slightly above 3 percent. 5-year inflation expectations from the NOP-survey are broadly in line with the recent development in YouGov/Citibank survey: Longer run inflation expectations were slightly below 3 percent until the end of 2009, while the two last observations in the NOP survey have been situated marginally above 3 percent

These inflation expectations are somewhat higher than the inflation target of 2 percent of the Bank of England. This may reflect the fact that inflation has been higher than the target during years before financial crisis. The fact that inflation expectations are higher than the target raises doubt whether the public has confidence in the inflation target. This may signal that the central bank has challenges with respect to its credibility.