Inflation expectations are on the rise, which might make the Fed’s job of lowering inflation a lot more difficult.
Inflation expectations are on the rise, which might make the Fed’s job of lowering inflation a lot more difficult.
I nflation expectations for both the short term (see the latest NABE Outlook Survey or University of Michigan one-year inflation expectations) and long term (see either the Survey of Professional Forecasters ten-year projections or the University of Michigan five-year inflation expectations) have recently risen significantly, alongside actual inflation, which is cause for concern.
In his most recent Federal Open Market Committee (FOMC) press conference, Fed chairman Jerome Powell said the latest jump in the monthly University of Michigan inflation expectations data was “quite eye-catching and we noticed that.” This followed the FOMC’s decision to raise the federal funds rate by 0.75 percent, rather than 0.5 percent, on the heels of the latest CPI inflation data (which showed core inflation prices to be sustainably rising in a month-over-month basis in areas such as housing).
While I’ve warned since early 2021 that inflation could be on the rise following copious amounts of fiscal stimulus in the form of social transfers, the rise in long-term inflation expectations is a new development that should be particularly concerning for those following the New Great Inflation.
Macroeconomic theory since the rational-expectations revolution of the 1970s and 1980s (which was developed in part in response to old Keynesian theories being unable to explain the Great Inflation) has posited that inflation expectations are a key driver of sustained inflation — that is, inflation expectations are (in a sense) self-fulfilling.
If the recent inflation were truly “transitory” and merely a one-time change in the price level caused by supply chains or the Russian invasion of Ukraine rather than a sustained increase in inflation, then long-run inflation expectations wouldn’t be rising in the way they are now.
Keeping inflation expectations (especially long-term expectations) close to a central bank’s 2 percent target is essential because inflation expectations becoming untethered from 2 percent (which inflation expectations appear to slowly be doing now) can cause more sustained inflation according to theory, traditionally at least.
More recently, there’s been a significant (somewhat more empirical) debate as to what degree inflation expectations matter for causing sustained inflation. Fed Board economist and long-time Federal Reserve inflation expert Jeremy Rudd weighed in on this discussion last year. Rudd argued that inflation expectations don’t matter as much as economic theorists previously thought in determining inflation. Studying the effects of monetary policy and other macroeconomic aggregates is generally very difficult, since policy is “endogenous” to macroeconomic variables. In other words, this means that while monetary policy (the level of the federal funds rate) affects inflation, the level of inflation will also determine the level of the federal funds rate. This makes empirically testing such theories (like whether increased inflation expectations actually causes sustained inflation) difficult. Inflation expectations and inflation are certainly correlated, but in the absence of any easy way to disentangle the data or find some sort of natural experiment like an unexpected shock to inflation expectations, the extent of causation (if any) becomes a much more difficult question.
Nonetheless, however difficult the question, the Fed will still be sure to err on the side of caution and monitor inflation expectations. The central bank will use any observed slowdown in the rise in inflation expectations following its current federal funds rate liftoff as a proxy to assess how effective those hikes are likely to be at tackling inflation.
If a single CPI inflation print along with the jump in University of Michigan inflation expectations caused the FOMC to implement a 0.75 percent hike in June rather than 0.5 percent, whether the Fed chooses to opt for increases at the higher end of the range could hinge on whether future inflation expectations data comes in hot.
One innovative data series the Fed is sure to be following is the new weekly inflation expectations survey run by Morning Consult and the Cleveland Fed called the Indirect Consumer Inflation Expectations (ICIE) index, which provides more frequent gauges of inflation expectations than the monthly University of Michigan inflation-expectations data. Olivier Coibion of UT Austin and Yuriy Gorodnichenko of UC Berkeley have done great work running their own inflation expectations surveys of CFOs. In a recent paper, they found that inflation expectations did not move much at all in response to the Federal Reserve’s announcement of the adoption of Flexible Average Inflation Targeting (FAIT) in 2020, one of the biggest long-term policy shifts announced by the Fed in decades.
If it’s really the case that it’s difficult for the Fed to meaningfully move inflation expectations on a tight time frame, inflation could potentially be here to stay longer than we anticipate. After all, it took more than a decade for the Fed to move inflation expectations down to 2 percent after, like most developed-country central banks, it originally adopted inflation targeting in the early 1990s. Prolonged inflation would not be pretty, especially for the poor, who experience higher inflation rates than the average consumer as the Foundation for Research on Equal Opportunity inflation inequality indices show; food and gasoline tend to be a bigger part of their consumption basket than the median-income consumer, and consumption makes up a larger fraction of the poor’s income.
Rest assured, the Fed will be following inflation-expectations data closely going forward as it contemplates its next federal funds rate moves.