Inflation Expectations: Main St. Versus Wall St.

The Fed wants you to know that inflation isn't a problem.

Which might be why investors were a little confused after today's rate decision which had the Fed keeping rates unchanged. Immediately after the non-move was announced, Treasury yields rose as traders bet on the notion that the Fed statement revealed a hawkish bias within the FOMC -- inline with much of the Fedspeak in the last month. But rates dove lower within minutes as the finer details of what the FOMC had to say were digested. Of particular importance was this sentence in the third paragraph: "The Committee expects inflation to moderate later this year and next year."

Here is the trading chart for 2-year Treasury bond right around the time of the Fed decision:

Keeping inflation expectations in check is a key part of what the Fed does, so although investors seem to be following the Fed's lead, it's another matter for consumers who have seen food and energy price hikes for the past year. It also couldn't have been welcome news for the Fed when recent reports indicated Americans believe inflation will be somewhere between 5.1 percent and 7.7 percent in the next year. The Fed doesn't forecast Consumer Price Index figures, but its range for another metric -- the price index for personal consumption expenditures -- is 1.7 to 2.0 percent in 2009. And according to the Survey of Professional Forecasters, CPI inflation should be around 2.4 percent. But before we shrug off the higher consumer figures, it's worth looking back at historical inflation projections.

The chart below shows 1-year-ahead inflation forecasts from the University Michigan Survey of Consumer Sentiment (green), the Survey of Professional Forecasters (blue), and the actual annual change in CPI at the time (dotted gray):

It's not easy to tell, but consumers have actually been slightly more accurate than the pros in predicting inflation one-year out. And an interesting trend emerges when comparing the difference between pros and consumers forecasts:

The level of disagreement between the two groups is reaching early 1980's highs. Back then, it was the pros who were predicting higher inflation, but now the situation is reversed.

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