By Jamie McGeever

ORLANDO FL (Reuters). ‘Inflation expectations’ are likely to be two of the most scrutinized terms in financial market or central bank circles. These words play a key role in determining monetary-policy decisions.

These two words may not be very meaningful.

Federal Reserve economists published recent papers which questioned the validity of the belief that an inflation outlook according business, market or household expectations can be a reliable guide to actual outcomes.

Because any central bank that has a mandate for price stability, like the Fed, must temper and guide the public’s inflation expectations. Millions of Americans live every day with the impact that policymakers have on changes in their perception of inflation.

However, a Cleveland Fed paper published this week (http://) indicating that the relationship between inflation expectations and future inflation was at best patchy and, at worst, almost non-existent.

Inflation prediction is difficult for consumers, but it’s not much easier for financial markets.

This paper follows a report by Fed staffer Jeremy Rudd https://. Rudd warned last month that believing in this relationship between actual and expected inflation “has no compelling theoretical or empirical basis” and that it could lead to policy mistakes.

A solid foundation of expectations helps ensure that the economy is running smoothly. This allows consumers and businesses to make sound investment and spending decisions. This benign environment helps to achieve the Fed’s inflation targets. It completes the circle.

The Fed, however, is currently in trouble and the markets are in chaos as they deal with unprecedented price pressures. The highest inflation expectations in financial markets as measured using inflation swaps or breakeven rates is 2014.

The Fed may feel forced to tighten its policy sooner and more aggressively to maintain temporary inflation, according to a rising view. This is a path that many emerging markets central banks are well on, including Brazil’s. Those in advanced economies, however, seem to be slipping.

Clear risk: If current inflation pressures prove to be “transitory”, Fed policymakers claim, then increasing rates could slow growth and even cause a recession by choking off economic activity.

Are these the expectations that policymakers can place their trust in?

SPURIOUS LINKS

The Cleveland Fed paper analyses inflation expectations for four major groups: consumers (University of Michigan 1-year Consumer Surveys); professionals (Blue Chip Economic Indicators 1-year Forecasts); businesses (Atlanta Fed Survey); financial markets (Cleveland Fed Model including nominal Treasury yields and survey forecasts; inflation swaps data (Cleveland Fed model).

It found that there was a negative correlation between inflation expected and actually over the past decade in certain instances. “This suggests that expectations measurements have a limited capacity to accurately predict the next year.”

Since the 1980s, professional economists have had the most successful track records. Consumers are the worst. Markets, however have not been an accurate predictor of inflation overall since 2011.

The Atlanta Fed Survey of Core and Headline CPI Forecasts by Firms: “Our results suggest that it is more beneficial to simply base one’s prediction upon the average of inflation series,” the paper’s author says.

Fair warning, it’s difficult to predict the future. It is therefore understandable why people look back to see what is ahead.

Kit Juckes is the head of FX strategy for Societe Generale in London. He notes that expectations, which are a function past inflation, cause them to underprice future events until they experience high inflation. Then, they overprice inflation. At that point, it is possible for growth to be already heading south.

This can make policymaking more difficult. This chart shows that U.S. consumers overestimated inflation for the last decade. However, the recent negative spread suggests this may be changing.

Jeremy Rudd, Fed economist stated in a much more incendiary article last month that it is only because future inflation forecasts are based on expectations that we can believe expectations will influence future inflation.

He claims that there is no evidence beyond circumstantial evidence linking long-term inflation expectations to inflation’s long run trend and “no evidence whatsoever” as to what it might take in order for the trend to continue.

But policymakers, financial markets and regulators can only use the tools that they currently have until there is something better.

Juckes of SocGen stated, “It is undoubtedly the largest question of today, and instead of a clear understanding of how it operates, we only have market pricing and forecasts.”