The U.S. Seems to be winning its battle against inflation.
Prices have slowly begun to descend and hopefully, prices should
continue to come down.
At least that's what people expect to happen.
It turns out Americans' inflation expectations really do matter.
People really do behave in accordance with their expectations and with their sentiment
and attitudes towards the economy.
Inflation has moved down from its peak.
A welcome development.
It remains too high.
We are prepared to raise rates further.
Theoretically, conceptually, it makes sense.
If households really think we'll have 2% inflation, they can kind of make it happen
by changing their behavior.
But financial markets are anxiously awaiting to see if inflation is truly
decreasing.
My concern is there's too much confidence in the potential of how
this whole inflation thing plays out.
My biggest concern is that's already priced into the markets.
Consumer spending have been especially robust.
Additional evidence of persistently above-trend growth could put further
progress on inflation at risk.
The Federal Reserve cannot cool off the economy if they don't cool off consumers.
Here's how inflation expectations are measured, why the Fed cares so much about
them, and how the idea of higher prices in the future can actually manifest
them.
Inflation expectations are the rate at which people expect prices to rise or
fall in the future.
For decades, inflation expectations have been fairly stable and inflation was fairly
stable. But the coronavirus pandemic caused a massive shift in those
expectations. Or rather, think of expectations as inflation
mentality.
They use terminology like the inflation expectations, just like I don't know what
that is. A more approachable label is an inflation mentality.
What consumers believe may happen in the future can influence actual
inflation.
Inflation expectations refer to what people believe inflation is going to
be in the future.
It will be informed by what they're seeing now, and that's really what's going to be
affecting their behavior today, which is why we care about it.
Inflation expectations play a crucial role in the decisions made by the Federal
Reserve. It's part of how they meet their mandate to reach maximum sustainable
employment and maintain stable prices.
So the way I actually think of it is we're sitting in a car together.
The car is the economy and consumers are deciding what to do based on where they
think the road is going. But, at any time the Fed might stick a traffic light
somewhere or steer us into an off-ramp, then the road is going to look different
down the line. But, it's always going to take a while.
Like, the policymakers might make a small adjustment to the road down the line, and
it'll take a while for consumers to recognize the road doesn't look the way it
did before. You know, we talk about the Fed trying to hit the gas pedal on the
economy. Well, that car does not react immediately.
It's a slow-reacting piece of machinery.
It is the Fed's job to bring inflation down to our 2% goal.
And we will do so.
Take the Fed's annual 2% average inflation rate goal.
Declaring an inflation target is one way the central bank influences how
consumers should think about the power of their dollar.
There was one of the rate hikes that the Federal Reserve did
when Jay Powell went out before the microphone to explain why they did this.
The preliminary Michigan reading, it was quite eye-catching.
One of the factors in our deciding to move ahead with 75 basis points today was what
we saw in inflation expectations.
We're absolutely determined to keep them anchored at 2%.
And I was like, wow.
So that's an example of them wanting to make sure that those
stay in line, and I mean, they were very concerned about this.
For example, if households want to avoid higher prices in the future, they might
make big purchases now.
That behavior shift impacts prices, too.
Instead of waiting for the dishwasher to maybe break next year when prices might be
so much higher, they just go ahead and buy the dishwasher now.
And when lots of families do that, then that's going to put additional upward
pressure on prices and that's going to spell trouble for inflation.
The inflation in the 1970s, early 1980s, this was a problem.
I want to have a frank talk with you tonight about our most serious domestic
problem. That problem is inflation.
An inflation mentality had taken root.
What's interesting about the current inflationary episode is that we're not
seeing a whole lot of buy in-advance psychology at all, and this is consistent
with the inflation expectations that we were measuring.
People were expecting inflation to be high for a year, maybe two, but they
expected it to come down in the long run.
We have much better data right now as far as the Federal Reserve is concerned in
trying to measure inflation expectations.
We've only had two years of high inflation .
In the 1970s, they had a decade.
When Paul Volcker took on as Fed chair, he looked at this problem and
really put the United States in a recession.
Jay Powell as Fed chair has not said we need a recession.
The Fed has no intention of causing the recession.
I mean, they might. We might go into a recession.
Well, the Federal Reserve has raised interest rates, hoping to slow down the
economy and more specifically, slow down the rate of inflation.
And so far, they've been doing a pretty good job of it.
The Federal Reserve analyzes a ton of data and economic indicators to
determine its next policy moves.
The Federal Reserve is like the Hoover vacuum of data, so they're going to bring
in whatever they have.
And yet the one that gets a lot of focus is inflation expectations.
Like the New York Fed Survey of Consumer Expectations and the University of
Michigan's Survey of Consumers, which dates back decades.
And it's been doing this actually since 1946.
We interview about 600 people a month via phone.
We do a random digit dialing of cell phone numbers and we give them an
interview of about 45 minutes of a core questionnaire of about 60
questions that ask them all about the economy, how they feel about the economy
and, specifically of interest right now, is how they feel about inflation and where
they think it's going. We measure both short-term and long-term inflation
expectations.
Short-term inflation expectations are a reference point for predictions in the
near future.
As inflation started to kick into gear, consumers were really unhappy about it and,
in the beginning, they thought it might be something that was transitory, that maybe
wasn't going to stick. But eventually, of course, they realized that we were in this
new inflationary era.
And of course, short-term expectations went up a lot.
Inflation increased dramatically in 2022.
Since then, inflation expectations have come down moderately.
Now, over 2023, it's actually been really interesting.
It seesawed up and down, up and down, up and down over the first four months of
2023. And since then, it's come down a little bit and remained fairly stable.
For example, short-term expectations were influenced by supply chain constraints.
I think consumers had some recognition over the last year that there were factors that
were peculiar to the current situation, even if they might last for a while, they
didn't expect them to last forever.
Shifting to long-term inflation expectations, what do consumers think will
happen within the next few years?
The Fed talks a lot about long-run inflation expectations, and it's clear that
that's the measure that they care more about than the one-year expectations.
The Fed is absolutely trying to keep long-term inflation expectations down.
The Fed's interest rate moves have a lagging effect, meaning it may shape
financial markets before consumers change their behavior when the interest rates
shift.
At the end of the day, when those decisions are relevant to them, consumers are very
attuned to the total costs of buying a house, of buying a car,
buying large durable goods, of their credit card bills.
So, the longer inflation stays high, the greater the chances that people say,
oh, it's not going back to the way before the pandemic, inflation is here to stay.
5- to 10-year inflation expectations did come up as inflation started to
accelerate, but it's been between 2.9% and 3.1% per year for the
last two years.
It's been remarkably stable even as inflation has peaked
during the last summer and come down considerably since then.
Preliminary results from the September survey showed that long-term inflation
expectations fell out of that range and came in at
2.7%. That's closer to both the pre-pandemic inflation
expectation levels and the Fed's 2% inflation rate goal.
The long-term expectations in the Michigan survey are not
2%. They're a little higher.
But the whole point is like they're stable.
Inflation expectation measures are only part of the data analyzed by the
Fed.
I think there's reasons always to be cautious with data.
Well, the consumer has been resilient.
Companies are still making money.
Unemployment is still extraordinarily low and inflation is ticking lower and
lower.
I had the opportunity to listen to the Michigan survey.
When they got to the inflation expectation question, I mean, these are hard questions.
You know, it's not like everyone follows the CPI and knows what the inflation was
last month. And when I was listening to them, knowing how important inflation
expectations were at the Federal Reserve, I kind of took a deep breath,
right? Because, you know, any survey, it's hard, but it's
consistent over time.
One of the biggest fears is the wage-price spiral and the spiral can
start with consumers.
If people think inflation is going to be really high, even higher in the future,
they might try to negotiate higher income wage increases at their job, say.
Say companies oblige and pay up.
They could protect their bottom line by charging higher prices for goods and
services.
And so once this gets going, it can really get going.
We saw this to some extent in the 1970s where there were more unions and, in
general, people had cost of living adjustments.
So, we've seen this before.
And what happens then is the Federal Reserve has to come in and do a lot more
because they got you to get you to think differently.
And that's tough.
On the other hand, we're in a historically strong labor market, which was not the
case in the 1970s inflationary episode.
People have really strong income expectations, and that's precisely what is
supporting robust consumer spending right now.
We happily have seen no evidence of a wage-price
spiral. In fact, workers' wages for a long time, this has
changed recently, but for a long time, weren't keeping up with inflation.
So they may go in and ask for a raise, but they weren't getting it.
Fed Chair Powell recognizes the great strides that have been made to combat high
inflation but also noted that prices are still too high, especially since
this deceleration of inflation is still coupled with a strong
economy.
We are prepared to raise rates further, if appropriate, and intend to hold policy at
a restrictive level until we are confident that inflation is moving sustainably
down toward our objective.
The challenge that I see is the confidence that people, in general, have over
how inflation does come down and then interest rates and how this all plays
out. When we think about all of the various components of inflation, what's
going to bring it down?
Is that priced into the market today?
And I would say no.
It's too soon to declare victory in the inflation battle.
Based on this assessment, we will proceed carefully as we decide whether to tighten
further, or instead, to hold the policy rate constant and await further
data.
The wrong move could spike unemployment and cause even more economic pain.
The question is have they raised interest rates and slowed the economy
so much that it throws us into a recession?
The Fed does not control the economy.
The Fed doesn't even control interest rates.
They have an effect on them.
But there's all kinds of other things happening in the world that affect the
economy.