WASHINGTON, March 30 – Federal Reserve policymakers are facing mounting pressure to maintain control over inflation psychology as American families see their expectations for future price increases rise along with gasoline costs, while bond markets signal growing unease through climbing yields on Treasury securities.
Before the U.S.-Israeli conflict with Iran drove oil prices up more than 50% in just four weeks, central bank officials felt confident that public expectations about inflation, especially long-term price outlooks, remained “anchored” and aligned with the Fed’s 2% inflation target – a sign of trust in their dedication and capability to achieve their price stability goals.
However, with gas prices affecting consumers on a near-daily basis, airline tickets and other costs expected to follow suit, and global oil prices stuck around $110 per barrel, the Federal Reserve is carefully watching for any signs of movement in the various surveys and market indicators that reflect public sentiment about future inflation trends.
“Long-term inflation expectations are consistent with 2%, but they may also be a little more fragile,” Philadelphia Fed President Anna Paulson stated on Friday during a San Francisco Fed conference, noting several years of above-target inflation and the emergence of another potential price shock.
Poor performance at U.S. Treasury auctions last week, where elevated yields were partially blamed on investor concerns about inflation, preceded Friday’s University of Michigan survey results that revealed a spike in household price expectations over the next year.
“That is on everyone’s mind,” Fed Chair Jerome Powell commented during a March 18 press conference that focused heavily on questions about how the central bank evaluated the economic dangers posed by the Iranian war, particularly whether another price shock following five years of missing inflation targets could cause the public to lose confidence.
With oil prices continuing their upward trajectory, investors have eliminated any expectations for Fed interest rate reductions in the near term and are increasingly betting on the possibility of rate increases this year. Even subtle hints from central bank officials can alter market expectations and strengthen the Fed’s position that it takes inflation seriously.
This represents a difficult lesson that policymakers have committed to remembering. The inflationary mindset of the 1970s is believed to have prompted businesses and consumers to aggressively drive up wages and prices without a strong central bank commitment, a pattern that was only broken through severe rate increases that triggered a harsh recession in the early 1980s.
“I don’t think we are going to let it color our decision-making more than is appropriate,” Powell said regarding the lessons from five decades past. However, “it has been five years. We had the tariff shock. We had the pandemic. Now we have an energy shock of some size and duration. … It’s a repeated set of things, and you worry that’s the kind of thing that can cause trouble for inflation expectations. We worry a lot about that. We are very strongly committed to doing what it takes to keep inflation expectations anchored at 2%.”
EXPECTATIONS AT ‘THE CORE’ OF CENTRAL BANKING
The present circumstances point toward a more aggressive monetary policy stance, despite the absence of an established method for measuring what Powell describes as the Fed’s objective. Within an institution that debates interpretations of even fundamental data like unemployment figures, abstract concepts such as “expectations” become somewhat subjective – with various policymakers emphasizing different financial market or survey indicators of how public inflation perceptions might be shifting.
“Expectations are at the core of central bank policymaking,” said Ed Al-Hussainy, a fixed income and macro portfolio manager at Columbia Threadneedle, explaining that believable commitments to control inflation are viewed as essential to a central bank’s success.
Nevertheless, expectations cannot be directly measured and remain subject to interpretation.
Officials aim “to make sure that people believe they’ll do whatever it takes to keep inflation down,” Al-Hussainy explained. “But if you articulate what those expectations are, I think you lose a little bit of kind of the strategic ambiguity … You lose a little bit of that flexibility to make policy on a discretionary basis.”
Discussion about which measurements are most important may grow more intense in the upcoming weeks.
Several of the Fed’s preferred expectation indicators, including one calculated from securities prices that indicate projected average inflation for a five-year span starting five years from now, have remained relatively close to 2% even during the COVID-19 pandemic inflation surge.
However, some less stable indicators exist, and Fed officials have noticed. Beyond the anticipated increase in consumer inflation expectations last week – something central bank leaders have typically dismissed as unpredictable and overly affected by gasoline prices – the disappointing Treasury auction results were interpreted by investors as reflecting growing concerns about U.S. inflation.
Additional ongoing surveys, such as the New York Fed’s monthly consumer poll, are also viewed as demonstrating “anchored” expectations – and actually decreased in the short term according to the latest report.
But that information covered February, before what has now become a month of elevated and rising oil prices, stock and bond market instability, and no apparent resolution to a conflict that consumers are experiencing at gas stations and will eventually feel in other spending areas.
“We have had five years now of inflation at elevated levels, and near-term inflation expectations have risen again, so I am particularly concerned that yet another price shock could increase longer-term inflation expectations,” Fed Governor Michael Barr stated on Thursday at a Brookings Institution event in Washington. “We need to be especially vigilant.”
