Rising inflation expectations are the real worry for the economy

One of the biggest economic trends worrying people right now is the rise in inflation. Over the last year, the costs of many products have gone up faster than they have in decades. But even if the inflation surge is temporary, it could raise inflation expectations, and that could have a long-term impact on the level of inflation, interest rates, economic growth, and markets.

Except for the period when gasoline prices surged in 2008, inflation is now rising faster than it has in nearly 30 years. The sudden reopening of the economy, propelled by massive government support, created enormous increases in demand, while supply chain and labor constraints limited output. This classic demand-exceeding-supply inflationary environment has provided businesses with significant pricing power.

Most likely, the current inflation acceleration will moderate over the next year. Businesses will have more time to adjust output, while the government’s payments to households and businesses will largely disappear, moderating sales. Supply and demand will become more in balance.

So why worry about inflation? Because there is another concern that is not being discussed: Inflation expectations may be starting to get out of hand.

What are inflation expectations and why do we worry about them?

Inflation expectations are what households and business believe the rate of inflation will be over time.

Expectations of how costs will increase are crucial factors in business and household decision making. If a firm thinks its costs will rise by a certain level, it will need to find ways to cover those added expenses. It will look to improve productivity, but it will also likely need to raise prices.

On the household side, inflation affects purchasing power. People can spend their income now or save it and buy goods in the future. The higher the rate of inflation, the less that can be bought in the future. As inflation rises, spending gets shifted from the future to the present.

And, finally, interest rates could be affected. The rate that financial institutions charge for loans depends in part on the need to offset inflation. Their buying power is negatively affected the same way as households’, and they need to cover that potential loss. The higher the expected rate of inflation, the higher the loan rate.

The implication is that we need to watch not just the rate of current inflation, but what is happening to expectations about what inflation may be over time.

And inflation expectations are on the rise.

There are a variety of indicators of inflation expectations, but the trends are similar in just about every method that they are measured.

For example, the Atlanta Fed’s Business Inflation Expectations Index reached a level in June that is about 50% higher than it had typically been running. The University of Michigan’s measure hit its highest level in 13 years in May.

The St. Louis Fed’s May Breakeven Inflation Rate indexes are all at their highest level in about a decade. Even the survey of Professional Forecasters (of which I am a member) indicated that inflation expectations are increasing, and it takes a lot to get economists to change their long-run forecasts.

Though not every index has inflation expectations surging, it is critical that this issue be watched carefully because the 800-pound gorilla in the economic policy room, the Fed, worries greatly about what is happening to this indicator.

The key for the Fed is that inflation expectations don’t change greatly. This was highlighted in a 2007 speech by former Fed Chair Ben Bernanke when he said this: “Undoubtedly, the state of inflation expectations greatly influences actual inflation and thus the central bank’s ability to achieve price stability.”

The Fed has two primary goals, price stability and maximum employment. Those two mandates can come into conflict. If inflation is rising too rapidly, the Fed would need to slow growth. But that could affect employment levels. If unemployment is too high, the Fed might want to increase growth, but that could lead to rising inflation.

For Fed policy to work best, inflation expectations need to be largely insulated from the ebbs and flows of the daily flow of data. If that is the case, expectations are described as being well “anchored.”

When expectations change significantly and it appears that movement could be sustained, the Fed might have to alter policy to prevent the expectations from getting too high, because businesses would start factoring inflation into their economic decisions. “Unanchored” expectations could cause inflation to accelerate, forcing up interest rates.

Related to the anchoring of expectations is the concern that the perception of the rate of long-term inflation could change. It’s been decades since businesses have had the pricing power they now enjoy. Similarly, except for the baby boomers who lived through the periods of rapid inflation in the 1970s and early 1980s, few people have given inflation much thought over the last 20 years or more.

It is possible that an extended period of higher-than-“normal” inflation could fundamentally change both business and household perceptions of what the “normal” inflation rate will be over time.

The higher inflation rates and interest rates that would result from an upward shift in inflation expectations would affect everything, from mortgage rates to equity markets.

We are not near a point where the Fed must react to the change in inflation expectations. There are frequent ups and downs in the measures. But the longer the increase continues, the greater the likelihood the Fed will have to respond, and that could mean it starts raising rates.

Indeed, an enduring gap up in inflation expectations is not inevitable. But this indicator needs to be watched carefully as a more lasting change could affect the economy and the markets significantly.

Joel L. Naroff is the president and founder of Naroff Economics, a strategic economic consulting firm in Bucks County.