Central banks spend a lot of time talking about something nobody can directly see: what people think inflation will be in the future. These beliefs, called inflation expectations, can shape actual inflation almost as much as oil prices or wages. Understanding them helps explain why policymakers sometimes act before inflation shows up in the data.
What inflation expectations are
Inflation expectations are the rate of price increases that households, businesses and investors believe will happen over a given period, such as the next year or the next five to ten years. They are not forecasts in the formal sense. They are the assumptions people carry around when they make decisions about spending, saving, pricing and pay.
Short-term expectations tend to move with recent experience, especially prices people see often, such as food and fuel. Long-term expectations are more stable and reflect how much people trust the central bank to keep inflation near its target over time.
Why beliefs move prices
Expectations matter because they influence behaviour. If workers expect prices to rise by 5% next year, they will push for pay rises of at least that much. If businesses expect their costs to rise, they will raise their prices pre-emptively. Those actions can make high inflation self-fulfilling, a dynamic we explore in what is a wage-price spiral.
The opposite is true too. If people believe inflation will return to 2%, they are less likely to demand large pay increases or raise prices aggressively, which helps bring inflation down. This is what economists mean when they say expectations are “anchored”.
How they are measured
There are two main families of measures. The first is surveys. In the US, the University of Michigan consumer survey asks households what they expect inflation to be in one year and in five to ten years. The New York Fed runs its own survey of consumer expectations. In the UK, the Bank of England commissions a regular survey of public attitudes to inflation, and business surveys ask firms about expected price rises.
The second is market-based measures. These compare the yields on ordinary government bonds with inflation-linked bonds, such as US Treasury Inflation-Protected Securities or UK index-linked gilts. The difference, called the breakeven inflation rate, shows roughly what inflation investors are pricing in. Swap markets offer a similar measure.
Each has weaknesses. Surveys can be swayed by recent headlines and the price of petrol. Market measures can be distorted by liquidity and by investors demanding extra compensation for risk. Central banks look at a range of indicators rather than relying on one.
Why central banks watch them so closely
Credibility is a central bank’s most valuable asset. If people trust it to hit its target, it can respond to shocks more gently, because expectations will not drift. If trust erodes and long-term expectations start rising, the central bank may need to raise interest rates more aggressively to restore its credibility.
This is why a jump in long-term expectations can worry policymakers even when current inflation is falling. It is also why central bank communication matters so much. Clear guidance about the inflation target and how policymakers will respond helps keep expectations anchored. Our guide to what an inflation target is explains the framework behind that.
What traders do with them
Traders watch survey releases such as the University of Michigan figures for signs that expectations are shifting. A sharp rise in the long-term measure can push bond yields higher and lift the dollar, as markets anticipate a firmer Fed response.
Breakeven rates are watched in real time. Rising breakevens can support assets seen as inflation hedges, such as commodities and gold, while weighing on long-dated bonds. Falling breakevens may signal concern about growth or deflation.
Expectations also help explain market reactions to inflation data. A hot inflation figure that leaves long-term expectations unchanged is less alarming than one that pushes them higher.
The bottom line
Inflation expectations are beliefs, but they have real power. They shape wage deals, pricing decisions and central bank policy. Watching both surveys and market measures gives a useful sense of whether inflation is likely to stay contained or become entrenched. To see how well you understand concepts like this, take the free Samuel & Co trader assessment.
