Short or long, inflation expectations are too high

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Economists say household inflation expectations can be self-fulfilling prophecies, and a recent survey sends mixed signals. A new report from the University of Michigan showed on Friday that short-term inflation expectations are falling while longer-term ones are rising. But it’s best to ignore month-to-month volatility and focus on the big picture: Both readings are too high and they’re likely to keep the Federal Reserve aggressive in its fight against the upside. prices.

Respondents to the university’s consumer sentiment survey now expect prices to rise 5% over the next year, down slightly from 5.2% in the previous report, according to preliminary results released on Friday. In the long term, respondents expect prices to increase by 3% over the next five to ten years, compared to 2.9% previously.

In fact, both. Naturally, economists and Fed policymakers tend to focus on longer-term inflation expectations to determine whether expectations are well anchored. Fed Chairman Jerome Powell cited an upward shift in long-term inflation expectations from the University of Michigan as part of his rationale for the first 75 basis point interest rate hike from the central bank in June. (That number — a preliminary reading like Friday’s — was eventually revised down, prompting significant criticism of Powell’s decision-making process in this episode.)

Friday’s uptick in the longer-term reading is important for markets in that it influences Powell’s thinking, but it could well prove to be another blow in the relatively volatile small survey. In theory, rising long-term inflation expectations suggest a loss of confidence that the Fed will get inflation under control, and that the change in the psychology of inflation may ultimately lead to more inflation as people increase their purchases for fear that goods and services will be much more expensive later. They can also influence workers’ wage expectations and contribute to a wage-price spiral, in which firms are forced to pay more for labor and offset costs by raising prices.

For their part, short-term inflation expectations are neglected in political discussions because they are much more volatile. It takes a prolonged period of higher prices – and higher short-term inflation expectations – for longer-term expectations to rise. Yet new research from the Federal Reserve Bank of San Francisco this week showed, in particular, that short-term expectations are actually a bigger determinant of wage growth than longer-term ones. Indeed, wages have lagged inflation over the past year, and workers fearing another year of inflation could demand significant increases. There is ongoing debate about the typical magnitude of the impact of the transmission from inflation expectations to wage expectations (see this recent working paper from the Federal Reserve Bank of Cleveland, which found that the transmission was somewhat weak). But overall, the fall in short-term inflation expectations is significant and deserves as much attention as the slight rise in longer-term expectations.

Of course, the interpretation of inflation expectations is complicated and perilous even when the figures are consistent with each other. Economists still haven’t mastered how best to track them reliably, and evidence shows that survey responses tend to focus on volatile food and energy prices, not the broad basket. and representative of consumer goods that includes the main inflation indices. Even the concept of inflation is misunderstood by the general public, and survey data often presents very erroneous answers. In the most recent poll, 15% of respondents thought prices would rise by 15% or more, while 8% predicted deflation.

An encouraging development is that several different surveys are now confirming each other by showing a decline in short-term inflation expectations. The New York Fed’s Consumer Expectations Survey this month showed that expectations are falling, while an internet survey by Morning Consult, in conjunction with Cleveland Fed researchers, shows that “indirect” inflation expectations have been falling for weeks. Importantly, the Morning Consult survey attempts to address some of the challenges inherent in measuring inflation expectations by approaching the issue in a novel way, asking consumers by how much their income would have to increase to buy the same quantity of goods and services in a year. Broadly speaking, however, the readings remain among the highest in four decades. The longer they stay there, the greater the risk that consumers will begin to believe that volatile prices have truly reached a point of no return.

More other writers at Bloomberg Opinion:

• Don’t buy the Stock Rally? Smart Money Made: Robert Burgess

• Fed damage to housing market may have lasted for years: Allison Schrager

• Curb Your Enthusiasm for Good Inflation News: John Authers

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Jonathan Levin has worked as a Bloomberg reporter in Latin America and the United States, covering finance, markets, and mergers and acquisitions. Most recently, he served as the company’s Miami office manager. He holds the CFA charter.

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