Inflation Expectations Could Be a Freudian Slip for the Fed
Central banks would be ill-advised to tighten monetary policy just because consumers say they think inflation will be higher in 10 years’ time
By Jon Sindreu
Data suggest that households mostly don’t form independent long-run expectations, they gradually revise them based on present inflation./ PHOTO: TING SHEN/ZUMA PRESSThe fate of financial markets may depend on central banks’ analysis of consumer “inflation expectations.”
They risk venturing into Freudian pseudoscience more than sound psychology.
Inflation is running above 6% in the U.S. and could well go higher.
After recent doubts, though, Western central banks have gone back to stressing the temporary factors driving the consumer-price index higher.
Right now, investors seem to believe them: Stocks buckled under inflation fears earlier this week, but have since recovered.
Bonds are pricing in very low interest rates for decades, despite a near-term rate rise.
Is inflation about excess demand, and not just supply bottlenecks?
Some on Wall Street think so, since production of many key products is now above 2019 levels.
But as a report by the Bank for International Settlements showed Thursday, there is no clear answer to how high demand is overall: It is running ahead of supply because consumption remains abnormally geared toward goods rather than services.
Likewise, there are staffing shortages despite labor participation remaining below pre-Covid levels.
Left with little clarity, central banks may base their final call on a familiar boogeyman: inflation expectations.
Officials emphasize that these remain more or less anchored.
Market measures of inflation expectations in the U.S. have only leapt in the short and medium term.
The University of Michigan’s surveys of households show a similar pattern but, concerningly, even expectations five to 10 years ahead are now ticking up.
It is well known that, when inflation is very high, workers take it into account when timing big purchases and negotiating salaries.
During the inflationary spiral of the late 1970s, however, policy makers extended this notion by incorporating inflation expectations into their models as a self-fulfilling prophecy that is itself the cause of inflation.
Central banks became obsessed with manipulating psychology to keep these expectations on target.
But as a recent paper by Federal Reserve economist Jeremy Rudd pointed out, there is little science behind this idea.
Inflation can’t magically appear or disappear based on what households think: Workers need power to extract pay rises from employers.
Even then, research from the 1980s showed that, while expectations were playing a role in cost-of-living adjustments pushed by unions, they moved in lockstep with actual inflation.
This makes sense, because the data overwhelmingly suggests that households are ill-informed about macroeconomics.
Rather than form independent long-run expectations, they gradually revise them based on present inflation.
They can still react to it by changing how they spend, research shows—though often in ways that contradict the theory—but there is no reason to believe they put more stock in 10-year-ahead rather than three-year-ahead expectations.
All of these have proven of little use when predicting inflation.
Inflationary spirals disappeared after the 1990s not because workers received psychological therapy, but because they lost the political leverage to keep pushing wages above productivity growth.
Some investors posit that a post-Covid era of activist and distributive fiscal policy will change the balance of power again, but it is still a hypothesis: The U.S. private-sector unionization rate is just 6% and, while workers are getting paid more, this is in the context of a surge in corporate profits.
Whether an inflationary spiral is coming or not, central banks would be unwise to read too much into expectations, which are sure to keep grinding up if inflation remains elevated, rather than focus on labor-market reports. Sometimes a cigar is just a cigar.
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