An enduring lesson from the supply shock of the pandemic is that elevated inflation can become entrenched if a central bank does not address it right away.
The escalation of hostilities in the Middle East over the weekend could very well be the next step in a broader global supply shock.
Such a shock could affect both inflation and inflation expectations, which could tip the balance for global central banks from rate cuts toward rate hikes, similar to what occurred following the Russian invasion of Ukraine.
In trading after markets opened in Asia, the price of the global benchmark Brent crude reached as high as $81.40 per barrel.
Even before the weekend’s events, the Federal Reserve was grappling with rising short-term inflation expectations as it tries to determine whether that increase will prove to be transitory or not.
Two concurrent supply shocks have been shaping those expectations: the tariffs that are raising the price of goods, and the disruptions to the flow of oil that are leading to higher energy prices.
Both of these shocks help explain why the Federal Reserve remains on hold with any rate cuts even as the policy rate remains modestly restrictive. During the initial stages of the pandemic supply chain shock, the Fed maintained an accommodative monetary policy, which allowed inflation to take hold.
This time around, short-term expectations are again rising above the Fed’s 2% inflation target, as seen in surveys conducted by the Federal Reserve Bank of New York and the University of Michigan.
This deviation has gained the attention of Federal Reserve officials. Governor John Williams recently cautioned against allowing such a break to take place, saying that it runs the risk of permitting those rising expectations to manifest into structurally higher inflation.
Monetary policy, after all, is effective only when inflation expectations are well anchored.
On Friday, the Fed’s preferred measure of inflation, the personal consumption expenditures index, will be released for May and will provide an indication of whether consumers’ expectations of higher prices are being fulfilled.
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It’s not just short-term expectations either. Expectations for inflation in five to 10 years rose to 4.4% as one-year expectations increased to 6.6%, demonstrating consumers’ sensitivity to uncertainty around pricing.
The breakdown in the relationship between short- and long-term expectations and the Fed’s 2% target is evidence that the public does not consider this recent bout of inflation as transitory.
If short-term expectations continue to increase—a real risk considering the events of the weekend—what should have been the continuation of the Fed’s easing of interest rates could turn into a waiting period.
For monetary policy to be successful, the public must have confidence that in the long-term, the monetary authorities will act to return prices to their normal levels.
If not, inflation expectations will become unanchored, causing distortions in prices and consumer behavior. At the moment, long-term inflation expectations have risen to 1980s and early 1990s levels, pushing long-term interest rates higher and adding to the cost of capital.
In the sections that follow, we outline a range of inflation expectations as estimated by central banks, surveys of consumers and financial markets.
When inflation expectations are rising, households are likely to front-run the price increases on essential items while curtailing discretionary spending. We think this happened this year as tariffs were announced and household spending slowed.
Economists’ forecasts
Recent economic projections released by Federal Reserve board members and Federal Reserve bank presidents forecast that inflation will rise to 3% this year, with reductions to 2.4% next year and 2.1% in 2027.
We can see the makings of an inflation shock in the May estimates of inflation expectations by the Federal Reserve Bank of Philadelphia, which puts economists’ forecasts of inflation into a continuous curve.
That analysis has inflation reaching 3.3% in 12 months, 2.6% in five years and 2.5% in 10 years. This is significantly higher than last September’s across-the-board expectations of 2.2%.
Surveys of consumers
Surveys of consumer expectations underscore the uncertainty facing households and businesses
Last November, surveys by the University of Michigan had inflation moving lower to 2.6%. By May, consumers’ inflation expectations had increased to 6.6% before retreating to 5.1% in June.
In comparison, the New York Federal Reserve’s survey of year-ahead inflation expectations, which had fallen below 3% late last year, increased to 3.6% in April.
Market-implied expectations
Then there are investors, whose outlook underscores the Fed’s assessment that inflation expectations remain well anchored and are a pillar of the central bank’s pause even as public expectations deviate from the target.
The forward market is hedging bets on inflation continuing to move toward the Fed’s 2% target. The five-year/five-year forward stands at 2.4%, which comes at a time when the inflation rate has averaged 2.4% over the past three months.
The takeaway
Twin supply shocks driven by tariffs and the flow of oil have caused inflation expectations to deviate from the Fed’s long-term 2% inflation target.
As evidence of higher inflation appears in the hard data over the next few months, central bankers will need to answer an important question: Do they look through both shocks as transitory, or do they respond to the deviations from the target?
