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The meaning and mechanics of “inflation shocks”

Measuring expected vs. actual inflation

With inflation in the news, we look to the FRED graph above to reveal how much realized inflation has differed from expected inflation. The graph shows one measure of realized inflation from the Bureau of Labor Statistics and measures of expected inflation from the Federal Reserve Bank of Cleveland:

  • The blue line shows the monthly year-over-year change in the consumer price index.
  • The red line shows one-year-ahead inflation expectations recorded over the course of the year.
  • The green line shows the one-year-ahead inflation rate that was expected for February 2022 as of February 2021.

The distance between the blue line’s realized inflation as of February 2022 (7.91%) and the green line’s expected inflation for February 2022 (1.67%) represents an “inflation shock.” These shocks are important for future transactions in the economy.

Let’s use a hypothetical example to explain the actual inflation shock: Suppose that back in February 2021 someone agreed to pay you some nominal amount in exactly one year. At the time, you both expected that the payment would allow you to purchase only slightly less goods and services in February 2022 than you could have purchased when you made the agreement in February 2021, given that some inflation is likely to occur. As noted above, that expected amount was 1.67% less (shown by the graph’s green line).

In reality, as of February 2022, the prices of goods and services had risen 7.91% instead of the expected 1.67% at the time the agreement was made. So the payment received can purchase much less goods and services than what was expected in February 2021: 6.24 percentage points less than what was expected, to be precise. (7.91 – 1.67 = 6.24)

These surprises in inflation change the real value of any nominal contract, including previously agreed-upon salaries, fixed-rate mortgage payments, and government bonds with no built-in inflation protection. To see how inflation surprises affect one of the largest borrowers in the world—the U.S. government—see our On the Economy blog post.

How this graph was created: Search FRED for “Consumer Price Index” and select “Consumer Price Index for All Urban Consumers: All Items in U.S. City Average.” From the “Edit Graph” panel, change “Units” to “Percent Change from Year Ago.” Next, use the “Add Line” tab to search for and select “1-Year Expected Inflation” and click “Add data series.” Change the “Edit Lines” tab to edit Line 2 and change the “Units” to “Percent.” Next, return to the “Add Line” tab to select “Create user-defined line? [+]” and click “Create line.” Set both “Value start/end:” and “to” to be equal to the value of “1-Year Expected Inflation” in February 2021 (i.e., 1.67%). Finally, change the dates at the top right of the graph to be “2021-2-01 to 2022-2-01.” Note that, at the time of this writing, the data in the graph matched the values described in the text; but inflation data are frequently revised, so discrepancies may arise.

Suggested by Yu-Ting Chiang and Jesse LaBelle.

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