The Conference Board will begin publishing inflation expectations with next week's consumer confidence report for May, a shift in policy that is sure to grab investor attention especially at a time when high energy prices are raising inflation concerns and blurring expectations for Federal Reserve policy. The Conference Board has been compiling consumer inflation expectations since August 1987 but had restricted access to the data to subscribers. Occasionally whispers of the data would, however, pop up in the markets. The Conference Board has decided to change its policy because of public demand for the data.
Each month a sample of about 4,000 consumers fill out questions ranging from income expectations, to job expectations, to inflation expectations. For the latter category, respondents are asked to estimate the rate of overall consumer inflation 12 months out. Respondents choose among a range of inflation changes from which the Conference Board calculates a specific rate.
Comparing psychology with actual inflation
The above graph compares the Conference Board series (in pink) with the actual year-on-year change in the consumer price index (in blue). The first feature that stands out is that consumers routinely over-estimate inflation. This is as much a question for psychologists as it is for economists. And here's where a second feature stands out, that consumers, despite being asked specifically to gauge future inflation, seem to gauge the current rate of inflation (again, probably a question of psychology).
The most important thing for us is the direction of change, and here consumer expectations match well with actual changes. Consumers were right on with the Gulf War in 1990, reacting immediately to spiking energy prices. Expectations remained rigid despite declining price increases in 1997-98, but consumers did react to rising prices during the Y2K boom. Once again declining inflation rates, this time surrounding the 2001 recession, did not have much impact on expectations. But, as shown in a closer look in the graph below, rising inflation rates did have some effect on expectations during the onset of the Iraq War in early 2003. Expectations showed an especially sharp reaction to Hurricane Katrina as well as some reaction to the very recent surge in energy prices.
Upward effect of energy prices
Looking at just changes in energy prices in the graph below confirms how important they are to consumer expectations, at least when energy prices are on the rise. A nearly 20 percent spike in energy prices following the Gulf War triggered a jump in CPI expectations to a peak of 6.4 percent in October 1990. It wasn't until Katrina that expectations ever rose again beyond 6.0 percent, hitting a record 6.8 percent in September.
A closer view in the graph below shows the recent action more clearly and how well directional changes between overall expectations and energy prices match up. The graph also highlights the inflexibility of expectations to predict easing price pressures. Actual contractions in energy prices during 2001 and 2002, let alone the recession, seemed to have no effect on expectations. Also having little to no effect was the sharp energy price slowdown in 2003. This may be important to remember if and when energy price increases recede and begin to soften the actual rate of overall inflation.
Bottom line
Our thanks to the Conference Board for allowing us to share an early view of the new public addition to their confidence report. Watch for the May results next Tuesday (May 30) to see whether any changes in consumer perceptions of inflationary pressures affect overall expectations for inflation data. The May consumer price report, out in mid June, probably ranks second to the employment report in importance right now, both for the markets and of course for FOMC policy makers who next meet in late June.
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