The Federal Reserve Closely Watches Consumer Expectations for Inflation

Key Takeaways:

• Federal Reserve officials closely watch surveys that show consumers’ expectations for future price increases.
• If consumers and business owners believe price pressures will ease, then they generally behave in ways that make that happen, according to Fed officials.
• Consumer expectations for inflation are beginning to come in line, giving Fed officials more hope that inflation can eventually be brought back down to target.

When Federal Reserve officials meet to discuss inflation and interest rates at the end of the month, they will take into account many factors, like the Consumer Price Index (CPI) and the unemployment rate. But there’s one data point Fed officials often highlight that might surprise you: what consumers like you think about inflation.

As Fed officials have crisscrossed the country talking about economic conditions and interest rates as of late, they have emphasized the importance of where consumers believe prices will be in the future.

“Inflation expectations, we think, are an important part of driving actual inflation and we want them to be at levels that are consistent with 2% inflation,” Federal Reserve Chair Jerome Powell said earlier this month at a Stanford University event.

Consumer Surveys Keep Tabs on Price Expectations

There are several places that the Federal Reserve can go to see what consumers are thinking about prices, including the University of Michigan’s Consumer Sentiment survey and the Conference Board’s Consumer Confidence survey. Each asks consumers what they think the inflation rate will be in the future.

As inflation shot up in 2022 to show year-over-year price increases of as much as 9%, so did consumer expectations that inflation would remain high. During that time, the University of Michigan survey showed consumers’ year-ahead inflation expectations exceeded 5% for the first time since the 2008 recession and reached highs not seen since 1981.

Why Do Expectations Matter?

When consumers and businesses think higher inflation is ahead, they act accordingly.

“One of the funny things about economics is that people’s expectations—your expectation—for the future become self-fulfilling. So if all of us believe that inflation will be 2%, then we behave in a way that helps lead to inflation being 2%,” Minneapolis Fed President Neel Kashkari told a University of Montana audience earlier this month.

When businesses think inflation will remain high, they often set their prices to contend with that expectation. Conversely, workers will ask for larger pay increases to keep up with the inflation they predict is ahead.

“If price-setters and wage-setters in an economy believe that inflation will be at 2%, then that will actually happen,” Powell said.

Expectations Appear To Be Falling in Line

Despite setting interest rates at 23-year highs, inflation hasn’t yet been tamed. In fact, recent reports have shown price pressures may be creeping back up. But there are some indications the Fed has at least successfully gotten consumers to pull back their inflation expectations.

“Importantly, inflation expectations in the New York Fed’s Survey of Consumer Expectations are now again within their pre-COVID ranges at all horizons, consistent with other measures of inflation expectations,” New York Fed President John Williams said earlier this month.

And it’s not just consumers’ expectations that the Fed follows, with Powell noting that officials also consider surveys of businesses, as well as other forecaster models and market indicators that can give information about the likely path of prices.

“All of those are saying that the public does believe—and it’s a good thing because it’s true—that inflation will go back down to 2%. So that’s very assuring,” Powell said.

Fed Has to ‘Go All the Way’

Not only does the Federal Reserve consider what the public thinks about inflation, but officials are also mindful of how the public perceives the central bank’s credibility. In other words, it’s important to the Fed that you believe it is serious about fighting inflation.

In their remarks, Powell, Kashkari, and other officials said it is crucial the Federal Reserve hit its annual target of a 2% inflation rate for that reason. They’ve also argued against changing the Fed’s target to a higher number because that would undermine confidence in the central bank.

“We have to go all the way. Because if we stop short, then you all are going to say, ‘maybe they will stop short next time,’ and that undermines confidence in the Fed,” Kashkari said.

By closely monitoring consumer expectations for inflation, the Federal Reserve aims to guide actual inflation towards its target rate. As consumer expectations align with Fed goals, there is hope that inflation can be managed effectively in the future.