FRBSF — Can We Rely on Market-Based Inflation Forecasts?

Conclusions

We find that market-based measures of inflation are poor predictors of future inflation. In particular, they perform much worse than forecasts constructed from survey expectations of future inflation, which incorporate all the information used by professional forecasters. Interestingly, a simple constant inflation rate corresponding to the Federal Reserve’s 2% inflation target consistently performs best. While our analysis is based on a short sample that displays a lot of volatility during the Great Recession, our results appear quite robust as they are consistent across two subsamples.

Our results add to the discussion about how much attention policymakers and professional forecasters should pay to market-based inflation forecasts. These measures mostly reflect current and past inflation movements, and do not contain a lot of useful forward-looking information. Idiosyncratic market forces and inflation risk premiums appear to be important drivers of market-based inflation expectations. Overall, it is important to keep this caveat in mind when interpreting market-based inflation expectations.

FRBSF Economic Letter
Can We Rely on Market-Based Inflation Forecasts?
Michael D. Bauer, senior economist in the Economic Research Department, and Erin McCarthy, research associate in the Economic Research Department
ht Mark Thoma at Economists View