Will Higher Inflation Expectations Force the Fed’s Hand?

Despite a newly agreed-to ceasefire in the Iran war, the risks are rising that price-shocked consumers and businesses won't expect the inflation spike to be temporary.

Higher inflation expectations could become self-fulfilling, analysts say, as businesses pass on higher expected costs to customers and employees’ requests for raises turn into an unhealthy spiral.

The fear is a replay of the 1970s, when years of punishing inflation ended only after the Federal Reserve strangled the economy with nearly 20% interest rates.

Markets see little risk of inflation spiraling out of the Fed’s control this time and forcing drastic Fed hikes, especially after this week's ceasefire. But analysts don't expect a quick return to normal for oil prices or other commodities facing supply constraints, either.

That could force inflation expectations higher, as the public expects even more delays in a return to the Fed’s 2% inflation target. Inflation reached as high as 9% in 2022 before settling to 2.4% before the war started.

“The longer the Fed doesn't get inflation back to target, the more likely it would seem that people start to believe they're not able or willing to do so,” said Ryan Swift, chief U.S. bond strategist at BCA Research.

Persistent inflation expectations can keep prices rising longer, affecting borrowing costs, wages, and investment decisions. This raises the risk of prolonged economic pressure for consumers and businesses.

It’s a risk that Fed officials are monitoring, with some seeing bigger risks to inflation expectations than others. Most Fed officials, however, agree that a return to their 2% target “could be slower than previously expected,” according to minutes of their meeting in mid-March.

The Fed “still has a lot of inflation-fighting credibility,” Swift said. That could help the Fed stick to its textbook response of looking past supply shocks, treating them as one-off episodes where inflation settles back to normal. With inflation risks contained, the Fed could focus more on keeping interest rates lower to prevent rising unemployment if growth takes a hit.

But that playbook is scrambled if inflation expectations become unmoored.

“That’s the critical problem the Fed needs to and wants to avoid,” Swift said.

The Fed’s ability to look past supply shocks relies on the assumption that inflation expectations are “anchored” near the Fed’s 2% target.

That may well hold true among professional economic forecasters, but consumers have seen a “dramatic deterioration” in their near-term inflation expectations in recent years, according to a study from Cleveland Fed economists.

In March, consumers anticipated inflation of 3.8% in the coming year, well above the 2.3% to 3% range they anticipated in the two years leading up to the pandemic, according to a long-running University of Michigan survey.

Indeed, inflation expectations from consumers and businesses have been “quite unanchored,” said Olivier Coibion, a University of Texas economist who co-wrote a new book on why those expectations matter.

That’s one reason why the price spike after the pandemic and Russia’s invasion of Ukraine shouldn’t have been too surprising, he argued. Now, the public’s still-high inflation expectations are getting hit with another shock.

That’s a parallel to the 1970s, Coibion said, when a spike in oil prices after the OPEC oil embargo in 1973 was followed by another shock to markets from the Iranian revolution in 1979.

“The risk of inflation surging again is extremely high,” he said. “In a way, this looks so much like the 1970s.”

The Fed is watching inflation expectations “very, very carefully,” Fed Chair Jerome Powell said last week, particularly since inflation never returned to 2%.

“It’s been a while, and we’re very mindful of that fact,” Powell said.

But he appeared relatively calm, saying inflation expectations “appear to be well anchored beyond the short term,” Powell said. The Fed can afford for now to “wait and see” the war’s impacts on the economy, he said.

That’s helped affirm markets’ views that the Fed will stay on hold this year. Markets now see a slight chance of a rate hike, a contrast to the couple of rate cuts that traders were expecting before the war began.

The bond market doesn’t seem alarmed about inflation, either, suggesting investors view the price shock as short-lived. One market-based measure, which reflects inflation expectations for five to 10 years from now, is at 2.10% and thus close to the Fed’s 2% goal.

At least one Fed official has warned against reading too much into those measures. Kansas City Fed President Jeffrey Schmid said recently he takes “little comfort” from longer-term measures staying subdued.

Their calmness reflects “the earned credibility of the Fed and the belief that monetary policy will keep inflation in check,” he said.

“It is now our job to follow through with policy actions that validate those expectations,” he said.

The Fed should be wary of over-emphasizing the stability of long-term inflation expectations if near-term ones keep climbing, according to Joe Brusuelas, chief economist at the accounting firm RSM US LLP.

“We think that investors should not repeat the same mistake that was made during the pandemic, when the Fed and others discounted shorter-term inflation expectations in favor of longer-term expectations,” he wrote.

Indeed, what matters for business price setting isn’t their long-term inflation expectations but the costs they anticipate in the year ahead, Coibion argued in a paper last year.

And after the post-pandemic inflation spike, many businesses learned it’s safe to raise prices when their competitors do.

“That's going to lead them to be very willing to pass on the cost increases that they're going to experience into their prices,” Coibion said.