With the Kansas City Fed’s Jackson Hole symposium kicking off on Friday, it makes sense to look at inflation expectations given the tensions between the central bank’s dual mandate of price stability and maximum sustainable employment.
At a time when employment growth has slowed while inflation is rising, policy decisions by the Federal Reserve will rest upon whether it thinks that higher tariffs will result in a one-time increase in prices or persistent inflation.
The primary metric that will underscore that critical policy judgment is inflation expectations.
The Fed’s credibility around the anchoring of inflation expectations has become entrenched among businesses that need a quotient of certainty to set prices and make decisions on resource allocation.
It is why, after a supply chain-induced increase in inflation, the Fed was able to engineer a soft landing with inflation returning to cyclical low of 2.62% without inducing a recession.
A look at a range of inflation expectations makes sense to provide a framework for those seeking to understand why the Fed has remained, and very could well remain, patient even as the labor market cools.
The question that policymakers, investors and firm managers must answer is will those expectations remain entrenched or will the changes in trade policy cause an increase in inflation?
A recent paper by Harvard Professor Alberto Cavallo makes the case that the U.S. economy may have reached a potential turning point and is experiencing a structural break in inflation excluding shelter.
The paper finds evidence of a broad-based increase in inflation trends beginning in February.
Given the substantial changes in how global trade is organized, can those that set prices and make hiring and investment decisions afford to maintain an entrenched set of assumptions on the direction of inflation?
Current complacency around entrenched inflation expectations is echoed by financial markets that have shrugged off the impact of the tariffs.
This is different from the experience of the 1970s and 1980s, when inflation reached above 12% in 1974 and then nearly 15% In 1980,
At that time, what we called runaway inflation prompted the Federal Reserve to impose extremely high interest rates, tough medicine that brought the global economy to a standstill and killed inflation.
We attribute today’s complacency in part to the consistency of Fed policy.
After decades of countering shocks to the business cycle, markets and the public have come to accept that the Fed will do whatever is necessary to contain inflation and to act appropriately when the economy is struggling.
We can see this in the Aruoba (ATSIX) model of inflation expectations from the Federal Reserve Bank of Philadelphia. The model confirms the consensus that inflation will increase to 2.9% in 12 months before receding toward the Federal Reserve’s 2% target over the next four to five years.
Finally, we note that the University of Michigan surveys of consumers point to inflation reaching 4.9% in a year, which differs dramatically from the 2.9% consensus of economists. In addition, the New York Fed’s estimate of year-ahead inflation expectations implies a 3.1% increase in inflation.
This suggests that consumers are likely to bring purchases forward, boosting GDP output now at the expense of GDP growth in the coming quarters.
That would be a recipe for stagflation and underscores our expectation of 1.1% this year as inflation moves to 3% or above by the end of the year.
