Written by: Taylor Tepper, September 12, 2022, https://www.forbes.com/advisor/investing/inflation-expectations/

When it comes to inflation, the Federal Reserve is focused on more than just the latest monthly numbers. It’s also striving to understand Americans’ inflation expectations.

The monthly inflation reports measure inflation now—and these days, U.S. prices are rising near the highest rates in four decades. Meanwhile, inflation expectations measure how American consumers believe inflation will look in the future.

Inflation expectations matter because prices end up reflecting, in part, what people expect them to be. The Fed’s monetary policy strategy needs to address both the causes of the historically high current rates of inflation as well as peoples’ hopes and fears about future prices.

The ability of Fed Chair Jerome Powell to manage both dimensions of prices will go a long way toward determining whether the Fed can reduce current rates of inflation without causing a recession.

“We’re talking about global economic forces intersecting consumer psychology,” said Steve Sosnick, chief strategist at Interactive Brokers. “The question is whether the Fed painted themselves into a corner.”

What Are Inflation Expectations?

Inflation expectations are what people believe inflation to be in the future. These expectations about future inflation matter because they affect people’s behavior in the present.

To better understand inflation expectations, Scott Ruesterholz, a portfolio manager at Insight Investment, suggests a thought experiment: Imagine that you’re planning to buy a new car one year from now.

In more normal times, when annual inflation is around the 2% level preferred by the Fed, you’d happily wait 12 months to buy a new car. There would be no reason to move up your plans because you’re not expecting the price of cars to change very much in a year.

But what if you noticed that the sticker price of new cars is rising pretty quickly? After monitoring the situation for a while, you might stop and ask yourself if it made more sense to buy a car right now, rather than waiting for months while prices kept gaining.

If you and a host of other automobile shoppers started buying cars all at once to get ahead of rising prices, automakers would take notice of the surging demand and further increase their prices. Higher car prices would contribute to even higher rates of inflation.

This is the essence of inflation expectations: Rising inflation makes people believe that prices will rise again in the future, causing them to demand wage increases and not delay purchases. Meanwhile, businesses boost their prices to accommodate higher wages and demand, which drives up inflation.

“When inflation expectations get too high, they impact the actual rate of inflation,” said Ruesterholz.

Why Inflation Expectations Matter

As prices for goods and services go up, workers start to feel the pinch. If wages don’t keep up with the average cost of living, then each dollar earned buys fewer goods. This is how inflation gradually erodes standards of living.

The obvious response would be for workers to demand higher wages. Bigger paychecks would help bolster workers’ purchasing power, which would also boost demand. And businesses would respond to increased demand by raising prices.

You’re probably starting to see that dynamic at work in the U.S. economy today. “Labor has more power than they’ve had in a long time, especially since the Great Recession,” said Sosnick.

Take a look at the wage growth tracker published by the Federal Reserve Bank of Atlanta. This handy tool compares the present 3-month moving average of wage growth to the year prior. According to the tracker, In August 2022 the 3-month average wage gain for all U.S. workers was +6.7%, compared to +3.9% in August 2021.

Nevertheless, workers are still falling behind. Inflation-adjusted earnings, according to the Bureau of Labor Statistics, fell 3% in July compared to the year prior. That tells us that the pay for average Americans isn’t keeping up with inflation.

What Are Inflation Expectations Now?

The Fed is trying to convince consumers and markets alike that despite missteps on inflation in 2021, they have the right antidote now. So far, Americans are buying what they’re selling.

Consider the Federal Reserve Bank of New York’s Survey of Consumer Expectations. In August, it showed that Americans believed inflation would rise 5.7% over the next year, down from 6.2% in July.

But expectations for where inflation would be in five years declined by 0.3 percentage points to 2% in August.

In other words, consumers are more pessimistic about inflation today—perhaps driven in part by expensive gas prices—but they’re getting more optimistic about inflation over the longer term.

Investors are making a similar calculation. The 10-year breakeven inflation rate, a common metric for longer-term inflation expectations among market participants, is hovering around 2.4%.

“Longer-term inflation expectations are typically more of a focal point for financial markets because shorter-term expectations tend to be more closely linked with gasoline prices,” said Josh Jamner, investment strategy analyst at ClearBridge Investments.”

How Is the Federal Reserve Managing Inflation Expectations?

The Fed has responded to inflation by raising the federal funds target rate four times this year so far, to 2.25% to 2.5%. It’s also continued to reduce its balance sheet, and it’s stopped buying long-term bonds.

Higher interest rates, combined with the easing of supply chain and production blockages as the world learns to live with Covid-19, may be the big reason that inflation expectations are moderating.

“With the Fed starting to move, people are talking about this being peak inflation,” said Tim Holland, chief investment officer at Orion Advisor Solutions. “It’s not going to get much worse.”

That’s the hope, anyway. Should higher inflation persist for longer than expected, interest rate hikes fail to halt price gains and supply chains remain tangled, then inflation expectations will start to rise.

And that would make the Fed’s job even harder than it is now.