US inflation can spring nasty surprises even if it seems to be cooling down

The sunnier view does have a lot going for it. Optimism comes not only from the decline in actual inflation, but also from the decline in expectations of future inflation. But take a closer look and it’s clear that some measures of expectations have not improved that much even as inflation has fallen. That means the situation is unstable and inflation could go back up again.

It’s not enough for inflation to hit the US Federal Reserve’s target of 2%. For a stable economy, inflation needs to be low and predictable going forward, like it was pre-pandemic. In many ways, the predictability of inflation is just as important as its level. Unpredictable prices act as a kind of tax on consumers. An asset offering variable returns is worth less, all else being equal, than one that offers fixed returns, because the predictability of knowing what your money is worth has tremendous value.

Uncertainty around inflation means a dollar is less valuable because you don’t know how much groceries will cost, or how far you can stretch your pay-cheque week to week. It also increases interest rates on longer term bonds, because investors and lenders need to be compensated for the extra risk taken.One of the dirty little secrets of economics, however, is that we have no good model for predicting inflation. The best we have is expectations of inflation.

Expectations can be self-fulfilling. They can also determine wage and price hikes, investment plans and asset prices. Expectations also explain why the Fed sets an inflation target: If everyone expects 2% inflation next year, then there’s a good chance that’s what we’ll get. So the Fed looks at expectations carefully, noting if they are “well anchored," for example; i.e., impervious to data on current inflation.

Expectation measurements can come from the bond market. The most popular are from bond derivatives and break-evens —or the difference between nominal and inflation-indexed bond yields. Both these measures are expectations of what inflation will be several years from now. They have been fairly stable even as inflation rose, indicating that the market expected transitory inflation all along.

This measure of expectations probably bolstered the Fed’s confidence that it was on the right track. If expectations suddenly increased, odds are there would be another rate increase. Of course, bond markets often get things wrong, and break-evens reflect some quirks in the bond market that have nothing to do with inflation. And in fact, the bond market has a terrible track record predicting inflation. So if the Fed cites bond-market expectations, it should not give anyone much comfort.

But there is another metric: household surveys. And if you look at median expectations of inflation a year or five years from now, both from the surveys of consumers from University of Michigan and from the New York Fed, consumers are also expecting inflation to fall next year. Even when inflation was high last year, they consistently expected low inflation in the next five years. Again, this is good news for the Fed and the chances of a soft landing. But here is where my pessimism creeps in: Confidence in those expectations is gone. Both surveys indicate consumers are much more uncertain about what inflation will be in the coming years, compared to back in 2020. By data analysis, median inflation expectations [show widening variation in 2021 and this has been the case since]. This suggests much less consensus and certainty around future prices. It helps explain why consumers still complain about inflation and have a dim economic outlook.

The uncertainty makes their dollar worth less, in risk terms. It also suggests that even if inflation continues to fall, it is not as stable as it was before 2020. When people are not confident in their expectations, it does not take much for fear of inflation to return. An oil price shock, a single bad inflation report, perhaps even high turkey prices—any of them could cause people to lose confidence in stability.

Before the pandemic, a generation of Americans had no experience at all of high inflation, while for millions of others, it was a distant memory at worst. That translated into low inflation expectations—and high confidence in those expectations, which in turn contributed to price stability in the US. A few years of rising prices, however, have shattered that confidence. It could take years of luck and sound monetary policy to get it back. ©bloomberg