A new approach to gauging inflation expectations.

Policymakers at the Federal Reserve and other central banks continually face the "Goldilocks" question--is monetary policy too tight, too loose, or just right? It would help if the central bank knew what real interest rates and expected inflation actually were, but these are not easy to observe. Visible indicators of these factors, such as Treasury inflation - protected securities (TIPS), survey measures of expected inflation, and nominal interest rates, are useful, but none of them alone quite tells the whole story. Nominal interest rates change with both real rates and expected inflation, Survey measures ask about only a few horizons, and measures of inflation expectations coming from inflation-protected securities conflate expectations with risk premia. Uncovering a purer measure is possible, but it takes a careful combination of the available data and the application of economic theory.

This Economic Commentary explains a relatively new method of uncovering inflation expectations and real interest rates and describes what light those numbers can shed on the current status of the U.S. economy.

People's expectation of inflation enters into nearly every economic decision they make. It enters into large decisions: whether they can afford a mortgage payment on a new house, whether they strike for higher wages, how they invest their retirement funds. It also enters into the smaller decisions, that in aggregate, affect the entire economy: whether they wait for the milk to go on sale or buy it before the price goes up.

Real interest rates also play a key role in many economic decisions. When businesses invest--or don't--in plants and equipment, when families buy--or don't--a new car or dishwasher; they are making judgments about the real return on the object and the real cost of borrowing. As such, real interest rates can be an important guide to monetary policy. As Alan Greenspan once explained, (1) keeping the real rate around its equilibrium level (which is determined by economic and financial conditions), has a "stabilizing effect on the economy" and it helps direct production "toward its long-term potential."

Modeling Interest Rates

For economists, a model is not a toy train or runway star, but rather, a simplified description of reality, usually involving equations. …

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