Inflation expectations are simply the rate at which people—consumers, businesses, investors—expect prices to rise in the future. They matter because actual inflation depends, in part, on what we expect it to be. If everyone expects prices to rise, say, 3 percent over the next year, businesses will want to raise prices by (at least) 3 percent, and workers and their unions will want similar-sized raises.
The expected inflation rate is important for central banks to achieve the goal of price stability. For example, in the US, the Fed’s mandate is to achieve maximum sustainable employment and price stability. It defines the latter as an annual inflation rate of 2 percent on average. To help achieve that goal, it strives to “anchor” inflation expectations at roughly 2 percent. If everyone expects the Fed to achieve inflation of 2 percent, then consumers and businesses are less likely to react when inflation climbs temporarily above that level (say, because of an oil price hike) or falls below it temporarily (say, because of a recession). If inflation expectations remain stable in the face of temporary increases or decreases in inflation, it will be easier for the Fed to meet its targets. However, because the Fed has fallen short of its 2 percent objective for some time, some Fed officials worry that inflation expectations may be straying from target.