Inflationary Expectations

Inflationary expectations are what households and businesses think the inflation rate will be in the future. Inflation is a rise in the general or average level of prices, a decrease in the purchasing power of a unit of money. Economic decisions involving long-term contracts, interest rates, and purchases of capital goods entail added complications, partly because households and businesses do not know what future inflation rates will be. If households and businesses expect prices of durable goods to rise in the future, they will speed up the purchase of these goods to beat inflation. If lenders expect higher inflation in the future, they will increase interest rates, particularly on long-term loans. Certain economic decisions force households and businesses to form opinions about what inflation rate to expect in the future.

Economists theorize that at any time there is a general, or census, rate of expected inflation. This expected inflation rate influences economic decisions and is directly linked to interest rates on a one-to-one basis. A 1 percent increase in expected inflation leads to a 1 percent increase in interest rates.

A difference between expected inflation and the inflation that actually materializes has real repercussions in the economy. Creditors gain when actual inflation comes in lower than was expected. In that case, the high interest rates that creditors charged to protect themselves against inflation turn into a windfall gain. Debtors gain and creditors lose when actual inflation comes in higher than was expected. In that case, creditors fail to protect themselves adequately against inflation, and debtors are able to borrow funds at low interest rates to buy durable goods before the prices of these goods go up. In summary, an excess of expected inflation above actual inflation redistributes income in favor of creditors, and an excess of actual inflation above expected inflation redistributes income in favor of debtors.

The adverse effects of inflation are largely minimized when actual inflation and expected inflation are equal, that is, when inflation is accurately anticipated. Shoe-leather costs and menu cost are two costs that inflation imposes on an economy even if the inflation is perfectly anticipated. “Shoe-leather costs” refer to the cost and inconvenience of the added number of financial transactions households and businesses undertake to avoid costs of inflation. Inflation, even if perfectly anticipated, erodes the value of cash holdings. In an inflationary environment, households and businesses reduce cash holdings and keep a larger proportion of wealth in the form of assets that offer some protection against inflation. This reallocation entails more trips to financial institutions to convert other assets into cash as cash is needed to finance daily transactions.

The cost of these trips is called “shoe-leather cost.” “Menu costs” refer to the cost of updating menus and price catalogues more often to reflect current pricing. In addition to these costs, even inflation that is perfectly anticipated imposes some drag on efficiency. Relative prices between goods and services exhibit some added volatility because of differences in the frequency at which various firms and industries change prices. The case of equality between actual inflation and expected inflation is theoretically possible but unlikely in practice.

Unlike other economic indicators, there is no ready gauge of expected inflation. An important step forward in measuring expected inflation came after the U.S. government began issuing inflationindexed bonds. The difference in interest rates between an inflation-indexed government bond and a regular government bond gives a measure of expected inflation at least among participants in the government bond market. Economists have also tried to measure expected inflation by surveying households and businesses and by extrapolating past inflation rates. It is likely that extrapolations and moving averages of past inflation rates are a major determinate of expected inflation. Attitudes toward current government budgetary and monetary policy may also influence expected inflation.

One of the most difficult economic situations occurs when deflation is expected. Deflation gives households and businesses an incentive to postpone purchases of durable goods, knowing these goods will be less costly in the future. Under deflation, holding on to cash becomes attractive because its purchasing power goes up daily. If expectations of deflation are strong enough, increases in the money supply will fail to increase spending or arrest falling prices.