'Can We Rely on Market-Based Inflation Forecasts?'

Michael Bauer and Erin McCarthy of the SF Fed:

Can We Rely on Market-Based Inflation Forecasts?, Michael D. Bauer and Erin McCarthy, Economic Letter, FRBSF: The Federal Reserve’s dual mandate requires monetary policy to aim for both maximum employment and price stability. Although employment has recovered since the recession, inflation has consistently remained below the Fed’s 2% longer-run objective. Because expectations of future inflation play an important role in determining current inflation, decreases in measures of inflation expectations based on market prices have raised some concerns. For example, between June 2014 and January 2015, one-year inflation swap rates, which measure market-based expectations of inflation in the consumer price index (CPI) one year ahead, dropped over 2.5 percentage points. Large decreases were also observed in breakeven inflation rates, the difference between yields on nominal and inflation-indexed Treasury securities, known as TIPS.

Market-based measures of inflation expectations are calculated from the prices of financial securities. Their advantage is that they are readily available at high frequency and therefore are widely monitored. However, they reflect not only the public’s inflation expectations but also other idiosyncratic factors that affect market prices, which are difficult to quantify. For example, they include a risk premium to compensate investors for inflation uncertainty and are affected by changes in liquidity, unusual demand flows, and, more broadly, “animal spirits” that change prices but are unrelated to expectations (see Bauer and Rudebusch 2015). Hence it is unclear how much useful information they provide, and how much one should pay attention to these rates when forecasting inflation.

If market-based inflation expectations provided accurate inflation forecasts, then one surely would want to pay close attention to their evolution. In this Economic Letter, we evaluate their performance in comparison with a variety of alternative forecasts for CPI inflation. ...

Conclusions We find that market-based measures of inflation are poor predictors of future inflation. In particular, they perform much worse than forecasts constructed from survey expectations of future inflation, which incorporate all the information used by professional forecasters. Interestingly, a simple constant inflation rate corresponding to the Federal Reserve’s 2% inflation target consistently performs best. While our analysis is based on a short sample that displays a lot of volatility during the Great Recession, our results appear quite robust as they are consistent across two subsamples.

Our results add to the discussion about how much attention policymakers and professional forecasters should pay to market-based inflation forecasts. These measures mostly reflect current and past inflation movements, and do not contain a lot of useful forward-looking information. Idiosyncratic market forces and inflation risk premiums appear to be important drivers of market-based inflation expectations. Overall, it is important to keep this caveat in mind when interpreting market-based inflation expectations.