Muddled inflation expectations no help for Fed
That's especially true today, and one more reason why the Federal Reserve is proceeding with caution.
Consumer expectations can, understandably, be volatile. The layperson is unlikely to have a firm grasp on how global supply chains, commodity prices or monetary policy lags affect prices. They could therefore easily be influenced - or spooked - by news headlines and current conditions. Survey responses are thus often based more on emotion than economic analysis.
This helps explain why the five-year inflation outlook in the University of Michigan's latest survey of consumers jumped to 3.9% in February. That's the highest since 1993, and was undoubtedly driven by legitimate fears about the impact U.S. President Donald Trump's tariffs could have on prices.
Yet the New York Fed's February survey tells a very different story. It shows that the U.S. public's five-year inflation horizon was unchanged from January at 3.0%. Indeed, this report's five-year outlook has been stuck in a 2.5-3.0% range for more than two years.
If that's not confusing enough, financial markets' long-term inflation outlook suggests there's no need to worry at all.
Five-year/five-year forward breakevens, a measure of expected inflation over a five-year period starting in five years' time, have been trending lower in recent weeks and were last trading around 2.1%. That's the lowest in two years, significantly below current annual CPI inflation of 2.8%, and practically at the Fed's 2% target.
This suggests investors believe tariff shocks will pass, the Fed will keep policy sufficiently tight to get inflation down, or growth will be weak. Or some combination of all three.
TENUOUS LINK
Given that consumer expectations, particularly over the shorter one-year and three-year horizons, are more volatile than market-based measures, how should policymakers make sense of these conflicting signals?
A Cleveland Fed paper from October 2021 suggests they should be taken with a grain of salt. It found that the predictive relationship of a range of inflation expectation gauges was hit and miss. And much more miss than hit.
Researchers found that consumers are particularly bad at predicting inflation. Again, this may be no real surprise given that people without a financial background often struggle to distinguish between the price level and the rate of price increases.
Though, for what it's worth, the Cleveland Fed researchers found that financial markets' predictive power isn't that much better.
Another 2021 paper by Fed staffer Jeremy Rudd went further, warning that the relationship between expected and actual inflation "has no compelling theoretical or empirical basis and could potentially result in serious policy errors."
That's a troubling conclusion given the importance policymakers put on keeping inflation expectations anchored.
But Fed Chair Jerome Powell doesn't seem worried. Speaking to reporters on Wednesday after Fed officials cut their GDP growth projections but raised the inflation outlook, he insisted that long-term expectations remain well-contained even if short-term ones are rising.
The recent University of Michigan survey was an "outlier", but will still be factored into policymakers' thinking along with all the other indicators they look at.
"We monitor inflation expectations very, very carefully, every source we can find. We do not take anything for granted," Powell said, adding that anchored inflation expectations are at "the very heart of our framework."
By Jamie McGeever;
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