Forward inflation expectations: Evidence from inflation caps and floors

Using daily prices of inflation caps and floors from 2012 through 2017, we document that caps are more sensitive to statements by the Board of Governors of the Federal Reserve or its Chair, while changes in floors are typically attributable to structural economic performance (e.g., labor markets, oil prices). We adapt nonparametric estimation methods to derive forward probabilities from the empirical distribution of historical U.S. inflation and estimate a regime-switching model for dispersion in the forward distribution. We link the transitions in regime to perceived changes in monetary policy and sources of major economic uncertainty. While our analysis is not able to assign a quantitative value to the change in inflation expectations (i.e., inflation expectations have declined by X%), we can confirm the direction of change at a daily frequency. Moreover, we can assign nearly all substantial movements to specific events, documenting asymmetry in the behavior of inflation expectations. We provide a structural interpretation of our findings, emphasizing the importance of a zero-lower bound over this time period. We also connect the dispersion in inflation expectations to newly developed measures of uncertainty [Jurado et al. (2015), Baker et al. (2016)]. Innovations to financial and macroeconomic uncertainty increase the dispersion in inflation floors, while decreasing the dispersion in inflation caps.