A funny thing happened on the way to the Federal Reserve’s latest rate hike. The Fed went big on June 15, raising the interest rates it controls by 75 basis points, or 0.75 percentage points – a sharp rise for an institution that usually tries to move gradually.
Why the urgency? As Fed Chair Jerome Powell made clear, he and his colleagues were afraid that expectations of inflation were becoming “unanchored,” which some economists argue could lead to inflation becoming “entrenched.” (The trench is losing its anchor? Time to call in the mixed-metaphor police? Never mind.)
According to Powell, one factor in the decision was a jump in the University of Michigan’s measure of long-term inflation expectations, which he described as “eye catching.” I and others warned about making too much of one month’s number, especially because other measures of expected inflation weren’t telling the same story – and to be fair, Powell acknowledged that this was a preliminary number that might be revised.
Sure enough, the number was revised down; apparently, inflation expectations aren’t losing their anchor after all. Oopsies.
In fact, the big story right now seems to be a quite sharp decline in market expectations of inflation over the medium term. The five-year break-even – the spread in interest rates between ordinary U.S. government bonds and inflation- protected bonds that are indexed to consumer prices – is an implicit forecast of inflation over the next five years; it’s down about a percentage point since March.
And the underlying picture is even better than this number suggests, because investors appear to believe that we’re only going to have a year or so, if that, of elevated inflation, and after that we’ll be back to roughly the Fed’s long-run target of 2% inflation as measured by the personal consumption expenditure deflator, which tends to run a bit lower than the Consumer Price Index.
As of Friday morning, one market-based estimate (more or less in line with others) has inflation running at 4.4 percent over the next year, but only 2.2 percent in the following 5 years.
Why do these estimates matter? Not because either financial markets or consumer surveys are especially good at predicting inflation (after all, neither saw the inflation surge of 2021-22 coming). The point instead is that most economists believe expected inflation is an important determinant of actual inflation.
Think of prices that are set a year in advance, like many wage contracts, apartment rents, and so on. In an economy in which everyone expects everyone else to raise wages 10 percent over the next year, employers will tend to offer 10 percent raises every time salaries are renegotiated, just to keep up, even if supply and demand for workers are roughly balanced. And this means that inflation, once it has become entrenched in expectations, can become self-perpetuating; the only way to bring it down is to engineer an extended period in which demand falls short of supply – that is, a recession.
This isn’t a hypothetical scenario: It’s more or less where we really were at the beginning of the 1980s, when everyone expected persistent high inflation, and it took years of high unemployment to get things under control.
The Fed, understandably, doesn’t want to find itself in that situation again, so it’s hypersensitive to any indication that expected inflation might be getting out of control. At the moment, however, there appear to be no such indications. In fact, various straws in the wind suggest that the Fed may be about to experience the flip side of its errors last year. Back then it got behind the curve, failing to see the ongoing inflation surge. Is it now behind the curve in the opposite direction, failing to see the impending inflation slump?
To be fair, official price numbers don’t yet show inflation slowing. Measures that exclude volatile food and energy prices or, alternatively, exclude extreme price movements suggest underlying…
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