Why Inflation Needs An Anchor

Like a self-fulfilling prophecy, when we expect a higher inflation rate, we tend to create it.

Consequently, the Federal Reserve hopes to anchor our expectations at 2%.

Now though, some of us expect 5% inflation.

Inflation Expectations

the Past and Present

By elevating interest rates, the Federal Reserve helped to pull down the inflation rate from 7.2% to, at 2.5%, a notch above its 2% target. (Instead of the CPI, the Fed uses the Personal Consumption Expenditures Index–the PCE.):

the Future

Asked about their inflation expectations, the Fed’s policy makers clustered around 2.7-2.8% for this year. Then, they project a dip that continues through 2027 and longer:

What we expect

The Fed’s consumer survey cited inflation expectations at or above 3%. Somewhat higher, the University of Michigan consumer sentiment survey reported that participants expected a whopping 5% inflation rate for the year ahead:

Our Bottom Line: Rational Expectations

Economics Nobel Laureate Thomas Sargent has been called a rational expectations pioneer. Explaining how expectations shape outcomes, rational expectations has provided insight about macroeconomic phenomena that range from inflation to bubbles. The theory suggests that people don’t just respond to what government decides. Also, by acting strategically, they affect what will happen.

The theory of rational expectations can show why it’s tough to prevent inflation:

• If businesses project inflation, they will increase prices to at least equal it. The result is a slew of higher prices.
• When workers expect high inflation, they negotiate a raise that exceeds it…thereby creating the inflation they feared.

Here, we have rational expectations at work. What we rationally expected determined the result.

So where are we? Most of us know that tariffs elevate prices. As a result, they have raised our inflation expectations beyond the Fed’s anchor.

And perhaps, created the inflation we hope to avoid.

My sources and more: Starting with the basics, we can see the inflation that the Federal Reserve cites here and here. However, for the insight, we can read this Brookings paper.

Please note that several of today’s sentences were in a previous econlife post.