by Chris Black
The Fed’s dual mandate (www.stlouisfed.org/in-plain-english/the-fed-and-the-dual-mandate) is to achieve maximum employment and price stability.
It defines the latter as an annual inflation rate of 2 percent (www.stlouisfed.org/open-vault/2019/january/fed-inflation-target-2-percent) on average.
To help achieve that goal, it strives to “anchor” inflation expectations at roughly 2 percent.
Anchored inflation expectations means they are relatively insensitive to incoming data.
So, for example, if the public experiences a spell of inflation higher than their long-run expectation, but their long-run expectation of inflation changes little as a result, then inflation expectations are well anchored.
If, on the other hand, the public reacts to a short period of higher-than-expected inflation by marking up their long-run expectation considerably, then expectations are poorly anchored.
If inflation expectations are well-anchored, policymakers can respond more aggressively to recessionary demand shocks and less aggressively to inflationary supply shocks, leading to better dual mandate outcomes.
The Fed’s public-facing credibility is also important in anchoring expectations.
The Fed has repeatedly expressed confidence (www.federalreserve.gov/mediacenter/files/FOMCpresconf20230920.pdf) in anchored inflation expectations, but the anchor appears to be weak as expectations are highly dispersed.
Standard economic thinking posits that a shift higher in weakly-anchored expectations will lead to higher realized inflation (www.federalreserve.gov/econres/feds/files/2021062pap.pdf), so officials place great weight on inflation expectations.
For example, businesses that expect higher inflation may raise prices in line with those expectations. Households that expect higher prices may decide to buy now instead of later, thus increasing demand and raising prices.
Regardless of the validity of theory, inflation expectations loom large in the thinking of policy makers, and any shift would prompt aggressive policy action.
This post reviews the importance of expectations being anchored, looks at a range of survey data showing they are weakly anchored, and suggests geopolitical events could shift inflation expectations in a worst-case scenario for the Fed.
Widely followed households surveys find that median inflation expectations are trending towards 2%, but they also show that this median is fragile.
The New York Fed’s monthly Survey of Consumer Expectations (www.newyorkfed.org/microeconomics/sce#/probinflout-2) finds that around 40% of respondents expect inflation to be higher than 4% in the medium term.
That result is notably higher than pre-2020 levels and has remained stable to rising over the past several months. Consistent with unanchored expectations, the share of respondents expecting deflation in the next few years is higher than it was pre-2020.
However, that share has also been steadily declining.
The University of Michigan’s monthly Survey of Consumers (data.sca.isr.umich.edu/get-table.php?c=YB&y=2023&m=8&n=all&f=pdf&k=6364d6209f0e4977a6ceef478bed80dc) tells a similar story for longer term inflation expectations.
Recent survey results indicate that around 30% of respondents believe inflation will be greater than 4% the next 5 to 10 years.
This contrasts sharply from the pre-2021 era where only 15% held such a view.
Note that the higher long term inflation expectations has been stable for two years.
Similar to the New York Fed survey, the share of respondents expecting deflation rose sharply recently and has been steadily declining.
Surveys of businesses also suggest fragility in inflation expectations, and a weaker anchor, but to a smaller extent than indicated by household surveys .
A survey by the Atlanta Fed (www.atlantafed.org/research/inflationproject/bie) of businesses in the Southeastern U.S. finds the average expectation to be around the Fed’s target but also reveals a recent increase in dispersion.
Almost 50% of respondents expected inflation to be above 3.1% over the next 5 to 10 years.
This is modestly higher than that reported prior to 2021.
Consistent with that result, the fraction of respondents who expected inflation to be lower than 1% over the next 5 to 10 years also declined modestly from the pre-2021 era.
Note that this survey is regional, while the other surveys in this post are national.
A new inflation survey from the Cleveland Fed finds that inflation expectations of corporate executives are not stable.
The Survey of Firm’s Inflation Expectations (www.clevelandfed.org/indicators-and-data/survey-of-firms-inflation-expectations) is a quarterly survey of the inflation expectations of CEOs.
One finding of the survey is that the average surveyed CEO now thinks that the Fed has moved its inflation target to 3%.
Assuming the perceived Fed inflation target reflects longer term expectations, the result would be in line with other findings within the survey that indicate a rise in both the average and dispersion of near to medium term inflation expectations.
As the Fed enters the late innings of its historic rate hiking cycle , it will carefully continue to monitor data, including expectations.
The threat of price resurgence, whether from real economy data or from a shift in expectations, would warrant aggressive policy action by the Fed to slow demand.
Measures of inflation expectations appear to be roughly centered around 2%, but the center is narrow and weakly anchored so can easily shift.
A weak anchor gives more room for inflation to resurge should expectations shift.
A return to hikes would strengthen the dollar significantly, and push Treasury yields higher, both of which can tighten the global economy (www.bis.org/publ/work592.htm) even further.
Recent data suggests (www.theguardian.com/business/2023/oct/31/eurozone-economy-shrinks-recession-ireland-austria-germany-france) the UK and Eurozone are on the cusp of recession, and both are structurally unable to keep up with the Fed should a shift in expectations warrant an even higher policy rate.
With recession, both the UK and EU may cut, widening interest rates differentials even further and siphoning capital away from euros and into dollars.
A spike in commodity prices from geopolitical developments could very quickly push inflation upward and tip median expectations comfortably above 2%, which would almost certainly equate to a resurgence next year.
However, this shift has not happened, nor have geopolitical events yet significantly impacted commodity supply, but this risk is nonetheless very real.