Why are Long-Run Inflation Expectations Falling?

Randal Verbrugge and I have just published a Federal Reserve Bank of Cleveland Economic Commentary called "Digging into the Downward Trend in Consumer Inflation Expectations." The piece focuses on long-run inflation expectations--expectations for the next 5 to 10 years-- from the Michigan Survey of Consumers. These expectations have been trending downward since the summer of 2014, around the same time as oil and gas prices started to decline.  It might seem natural to conclude that falling gas prices are responsible for the decline in long-run inflation expectations. But we suggest that this may not be the whole story.

First of all, gas prices have exhibited two upward surges since 2014, neither of which was associated with a rise in long-run inflation expectations. Second, the correlation between gas prices and inflation expectations (a relationship I explore in much more detail in this working paper) appears too weak to explain the size of the decline. So what else could be going on?

If you look at the histogram in Figure 2, below, you can see the distribution of inflation forecasts that consumers give in three different time periods: an early period, the first half of 2014, and the past year. The shaded gray bars correspond to the early period, the red bars to 2014, and the blue bars to the most recent period. Notice that there is some degree of "response heaping" at multiples of 5%. In another paper, I use this response heaping to help quantify consumers' uncertainty about long-run inflation. The idea is that people who are more uncertain about inflation, or have a less precise estimate of what it should be, tend to report a round number-- this is a well-documented tendency in how people communicate imprecision.

The response heaping has declined over time, corresponding to a fall in my consumer inflation uncertainty index for the longer horizon. As we detail in the Commentary, this fall in uncertainty helps explain the decline in the measured median inflation forecast. This is a remnant of the fact that common round forecasts, 5% and 10%, are higher than common non-round forecasts.

There is also a notable change in the distribution of non-round forecasts over time. The biggest change is that 1% forecasts for long-run inflation are much more common than previously (see how the blue bar is higher than the red and gray bars for 1% inflation).  I think this is an important sign that some consumers (probably those that are more informed about the economy and inflation) are noticing that inflation has been quite low for an extended period, and are starting to incorporate low inflation into their long-run expectations. More consumers expect 1% inflation than 2%.