Every financial calculation that you make is influenced by your expectations for future inflation:  how much to borrow, where to put your savings, and whether your last raise was a reason to celebrate or to start looking for a better job.  Even small decisions, like whether to buy a couple extra cans of tomato paste, are affected.  No dollar amount or interest rate is good or bad, except when compared to inflationary expectations.

Among the people who care most deeply about inflationary expectations are the people at the Federal Reserve who set short-term interest rates.  The reason they care is simple:   As long as inflation expectations are low, a brief shot of inflation through the economy does only moderate harm.  That changes once people start to expect higher inflation.  If that happens, getting back to a normal low-inflation environment requires a higher and longer-lasting level of pain throughout the economy.

The Fed uses various kinds of data to get a handle on inflationary expectations.  Recently, two measures have started to give very different signals.

One way to estimate inflationary expectations is to subtract the yield of inflation-indexed Treasury notes from that of ordinary Treasury notes.  The difference ought to be the inflation rate that investors are expecting.  The green line in the graph shows that calculation for 5-year Treasury notes.  The expected inflation rate is a bit above 2%, and has actually been dropping lately.

Another way to gauge inflationary expectations is to ask people what inflation rate they're expecting.  The University of Michigan does that every month.  The red line in the graph shows their results.  Until about a year ago, the survey result pretty much tracked along slightly above the "Treasurys minus TIPS" calculation (higher, but by less than a percentage point).  Since about April of last year, though, the University of Michigan survey has spiked up, and the difference between the two estimates now stands at more than 2.5 percentage points.

The implied rate from the TIPS is an estimate of inflation for the next 5 years, so one reading of the difference is that people expect the current surge of inflation to be temporary.  The series of Fed rate cuts since September last year strong suggests that the Fed thinks that inflation will come back down.  Fed policy makers have said as much:

Survey measures of households’ expectations for year-ahead inflation rose further in early April, but survey measures of longer-term inflation expectations moved relatively little.

-- Minutes of Federal Open Market Committee, April 29-30, 2008

I think it will be worth keeping an eye on that "Treasurys minus TIPS" calculation.  If the 5-year expectation of inflation begins to rise like the 1-year expectation of inflation, expect the Fed to take strong action.