One of the Federal Reserve’s errors during the pandemic was to discount public and professional short-term inflation expectations.
The Fed learned a difficult lesson in how short-term expectations have become just as important as professional metrics preferred by capital markets professionals and some Fed members.
One can expect that phrase “inflation expectations” to be repeatedly used by Fed Chair Jerome Powell at his news conference on Wednesday following the Federal Open Market Committee meeting.
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Central bank officials are suddenly having to recalibrate their policy framework to account for the oil and energy shock cascading through the American economy.
For years, near-term public expectations had largely been discounted in favor of longer-term indicators like the Fed’s 5-year/5 year forward breakeven indicator.
Before the pandemic, the public’s fear of inflation often overshot the actual level of inflation. The Fed would look past these concerns and focus on longer-term measures.
But the pandemic changed that. As prices surged, it was the public, and not the professionals, that was right, leading the Fed to now consider a broader array of inflation expectation metrics.
Now, after two weeks of war and a rapidly evolving energy shock, what are the metrics telling policymakers and the public?
The 5-year Treasury Inflation-Protected Security has jumped to 2.7%, up from 2.4% just before the war.
Wall Street’s preferred metric, the 5-year/5-year forward breakeven, stands at 2.3% and the 10-year TIPS is at 2.4%.
Other measures show continued upward pressure on prices. The University of Michigan’s one-year inflation expectations stands at 3.4% and the New York Fed’s one-year inflation expectations stands at 3%. Both are well above the Fed’s 2% target for inflation.
Given that the personal consumption expenditures index, the Fed’s preferred measure of inflation, stands at 2.8% and the core metric, which excludes food and energy, recently increased to 3.1%, the central bank will be focusing on the evolution of inflation expectations.
At the Fed, the consensus is that as long as long-term expectations remain in a range between 2% and 2.5%, then expectations are well anchored.
Still, short-term expectations are likely to play a much larger role in setting monetary policy.
Should those near-term expectations rise sharply as top-line energy prices feed through into the core, then the Fed will find it difficult to keep the federal funds policy rate near its 3% terminal rate estimate.
