Question

Explain how the expectations about future inflation can affect current inflation.

How do central banks influence inflation expectations.

Answer 1

Expectations about future inflation does have an impact on current inflation. Just as an example, if consumers expect future inflation to be higher, it makes more sense for consumers to pursue leveraged spending now ( fixed rate) than in the future. Similarly, employees who expect future inflation to be higher would demand a bigger pay raise in order to have positive wages growth (adjusted for inflation). Therefore, if future inflation expectation is that inflation will be higher, there is an increase in consumption spending and wages in the present. This translates into higher relatively higher inflation in the present as well.

In the same way, if future inflation expectations are lower, current inflation will trend lower as well as consumers postpone non-necessity consumption spending for future. The reason is low future inflation expectation also implies lower interest rates )cost of money) that will make leveraged spending attractive in the future for consumers. This reduces current demand for goods and services, which translates into lower inflation.

One of the key roles of the central bank is to ensure price stability in the economy. The central bank manages inflation expectations by monetary policy coupled with guidance on inflation in the future. The federal reserve uses Survey of Professional Forecasters to estimate potential inflation that is provided in the central bank meetings. Further, as rates are adjusted based on the inflation expectations, the inflation and consumer inflation expectation is altered.