By Peter C Earle
Deep within Friday’s University of Michigan (UMich) numbers was a worrisome sign for the Federal Reserve’s inflation-fighting efforts. While the focus of the UMich releases tends to be on their consumer and current conditions surveys, another of their reports suggests an entrenching of inflation expectations both over one- and five-to-ten-year periods. The University of Michigan one-year inflation expectations (median) surged to 5.1 percent from 4.7 percent, the first increase since March 2022, when energy prices surged. For the five-to-ten-year survey, consumer inflation expectations rose from 2.7 percent to 2.9 percent.
It is likely that the recent upsurge in the average US price of a gallon of gasoline, from $4.29 per gallon in mid-September to over $4.50 more recently, accounts for at least some of those mounting expectations. Other areas in which month-to-month price increases were observed in September were food (up 0.8 percent), transportation services (up 1.9 percent), and shelter (up 0.7 percent).
University of Michigan, Expected Inflation in 1 year (percent, median)
During inflationary periods, policymakers seek to ensure that expectations among consumers remain anchored. Consumer behaviors influence price setting by businesses. If individuals expect prices to rise substantially within the coming year, they are likely to purchase certain goods now, rather than wait. That behavior may stimulate increased production of the sought-after goods and, in turn, lead to higher prices. As former Federal Reserve Chair Paul Volcker said in 1979, “Inflation feeds in part on itself, so part of the job of returning to a more stable and more productive economy must be to break the grip of inflationary expectations.”
To some extent, rising inflation expectations derive from the increased sensitivity of a population that has known stable prices for a substantial period of time. Between 1992 and the end of 2019, inflation (CPI, year-over-year) averaged 2.3 percent, albeit with some volatility during the 2008 financial crisis. That level of price fluctuations is a fraction of what prevailed over previous decades, wherein inflation averaged 5.6 percent throughout the 1980s and 7.1 percent through the 1970s.
Yet unanchored inflation expectations do not only indicate concern about future prices. They additionally suggest that the credibility of the monetary authority charged with fighting the increase in prices is not sufficient to warrant inaction. A growing number hold the view that despite Fed assurances, the resolve to fight inflation is less earnest than the instinct to rescue the economy from a severe recession, and that the so-called Fed Put remains in effect. Parties as diverse as Wharton Professor of Finance Jeremy Siegel and the United Nations have been increasing pressure to stop raising interest rates, despite the growth and persistence of inflation.
Indeed, as pointed out last week, market implied policy rates show expectations of a Fed policy reversal emerging. In fact, whereas in June 2022, market participants saw interest rates reaching a peak in one year (June 2023) before declining, presently markets see the rate peak in March 2023.
Market Implied Policy Rates, 18 October 2022 (green) and 1 June 2022 (yellow)
The statement accompanying the UMich inflationary expectations report commented that “[i]nflation expectations are likely to remain relatively unstable in the months ahead, as consumer uncertainty over … expectations remain[s] high and is unlikely to wane in the face of continued global pressures on inflation.” The recent OPEC decision to cut production, as well downward pressure on the wealth effect from declines in the stock market and housing prices, may be sufficient to continue driving inflation expectations higher.
Add to all of that the growing gulf between what consumers and investors see versus what political figures are saying, and uncertainty over the future path of prices is likely to increase. If those expectations lead to consumption patterns being adjusted in anticipation of higher prices, a self-fulfilling prophecy may emerge. Herding, of sorts, may then thwart the effects of contractionary monetary policy measures to some degree. The Fed has a tough job ahead of it, one which may have just become a bit tougher.