A framework for thinking about inflation expectations and surprises
We provide a framework for thinking about the inflation outlook with Refinitiv Datastream data and Fathom Consulting analysis
To what extent can inflation expectations be measured, as they will be priced in it is inflation surprises that matter most from an investor perspective.
There are numerous ways of attempting to measure inflation expectations and none is perfect. This note discusses the strengths and weaknesses of two commonly-watched measures — household expectations and inflation swaps.
While consumer-based measures of inflation expectations appear very stable at low rates of inflation, market-based measures are highly correlated with recent outturns but only weakly correlated with future outcomes, possibly suggestive of adaptive behaviour on the part of investors.
Unexpected shocks are also a crucial driver of inflationary outcomes — measuring these can prove valuable in predicting short-term outcomes. Techniques such as principal component analysis can be used to synthesise the messages from numerous measures into a single metric of short-term inflationary pressures. Analysis suggests that these kinds of indicators can explain a subtantial proportion of short-term movements in inflation.
It is possible to design portfolios that allow for the more timely tracking of inflation surprises across financial markets.
We explore in our research paper below.