Sunday, September 22, 2013

Consumers' view of inflation diverges further from market-implied CPI

The scatter plot below compares UMichigan consumer inflation expectations to the 2yr market-implied inflation expectations from the Cleveland Fed (the 2-year TIPS are sufficiently liquid to prove a useful measure of short-term inflation expectations from the market.) The data is monthly and covers roughly the past 30 years.

Except for periods of unusually high inflation (highlighted in yellow), there doesn't seem to be a stable relationship. The consumer and the market seem to be disconnected.

Source: UMichigan, Cleveland Fed

Part of the issue of course is that the UMichigan survey focuses on what consumers think about general price increases going forward, while the Fed's market-implied measure is based specifically on the CPI (TIPS are tied to CPI). Consumer surveys are often criticized because consumers tend to respond to recent price increases, particularly the ones that are most visible. Market-based (breakeven) measures on the other hand tend to price the CPI going forward.
Wikinvest: - Typically, beliefs of households about future inflation are much higher than normal, and have a smaller role in impacting future inflation than investor expectations of inflation. The former is true because households tend to base their estimates of future inflation based solely on previous inflation, rather than on previous inflation in addition to other factors, like changing supply or demand.
It's easy to discount households as not being fully capable of "estimating" inflation changes going forward. A question for the academic community however is whether the consumer may simply be "sensitive" to a different "basket" of goods and services than what is covered by the CPI (it may be worth regressing the UMichigan survey against components of the CPI for example.) If so, what is that basket, and how does it interact with consumer sentiment? The basket may for example assign a higher weight to prices of gasoline, healthcare, rent, etc.

When the consumer is over 70% of the US GDP, someone should be asking about which products or services households are most sensitive to when it comes to price changes. That's a very different measure from the CPI, which is supposed to gauge price changes of the overall household consumption. Consumers may care more about prices of milk than of cell phones, even though both are consumed by households and included in the CPI.

Getting to the bottom of this question is particularly important now, as over the past couple of years the divergence between these two measures has become acute. The correlation between monthly changes in the UMichigan survey and the 2yr market-based inflation expectations is at the lowest level in 30 years. US consumers may be seeing/experiencing something the economists are not. Simply ignoring the consumer's view of inflation and relying on projections of the CPI may not be prudent, especially given the Fed's current monetary stance.

Source: UMichigan, Cleveland Fed



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