Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / How the Fed Reads the Ivory Tower Inflation Signal
Transcript
- Lucas: So, Luna, we've spent a lot of episodes lately talking about the numbers the Fed crunches — PCE, CPI, the yield curve. But today I want to talk about something squishier: what people expect inflation to be in the future. Luna: Right, and that's not just academic curiosity. Inflation expectations are kind of the ghost in the machine for the Fed. Lucas: Exactly. And the specific number I'm looking at right now is from the University of Michigan's consumer sentiment survey. It's a long-running monthly poll that asks households what they expect for inflation over the next year and over the next five to ten years. And these expectations feed directly into how the Fed thinks about its credibility. Luna: So, remind me — why do expectations matter so much? It's not just that people predict prices, it's that those predictions can become self-fulfilling. Lucas: Precisely. If households expect higher inflation, they're more likely to demand higher wages and accept higher prices, which actually pushes inflation up. So the Fed watches these surveys like hawks. And right now, the ten-year breakeven rate — that's the market-based measure of expected inflation over the next decade — is sitting at 2.30 percent. That's up a couple of basis points from last week. Luna: So the market's pricing in long-run inflation above the Fed's 2 percent target. But what's the Michigan survey actually saying? Do we have the latest reading? Lucas: We do, actually. The preliminary August reading came out last week, and the one-year ahead expectation ticked up to 3.1 percent, while the five-year ahead is holding at 3.0. Now, those are still in the range we've seen for the past year, but any upward drift gets the Fed's attention. Luna: And that's partly because the Fed has been fighting to keep those long-run expectations anchored at 2 percent. If they start to move up, that's a credibility issue. Lucas: Right, and that's why the Fed's communications folks are probably parsing every word of the Michigan report. The survey asks about personal finances, buying conditions, and it also captures sentiment around government policy. And then there's the partisan gap in responses — we've seen that widen a lot in recent years. Luna: The partisan gap, that's fascinating. I remember reading that Republicans and Democrats have very different inflation expectations depending on who's in the White House. Is that something the Fed actually adjusts for, or is it just noise? Lucas: It's a real issue. Some economists argue that the Michigan survey is capturing political sentiment more than actual price expectations. There was a paper a few years back showing that the gap between party groups widened dramatically after 2016, and it's been persistent. But the Fed still uses the aggregate number, because even if it's partially political, it still reflects how consumers feel about the economy — and that influences their spending. Luna: So, if expectations drift up, does that change the Fed's calculus on rate cuts? Because we're sitting at a fed funds rate of 3.63 percent, and the market has been pricing in some easing later this year. Lucas: That's the million-dollar question. The Fed has been very clear that it wants to see more confidence in inflation returning to target before cutting. And expectations are a key part of that confidence. If the Michigan survey starts showing a sustained move higher in long-run expectations, the Fed could hold rates higher for longer, even if the actual inflation data is cooling. Luna: So, the Fed is essentially using the survey as a gut check on its own credibility. If people don't believe the Fed will get inflation down, then the Fed has to work harder. Lucas: Exactly. And that's why I wanted to drill into this particular indicator. It's not as closely watched as CPI or the jobs report, but it might be just as important in the current environment. We've seen core PCE remain sticky at 130.3, up from 130.09 a month ago. And the CPI is still hovering at 332.8. So the actual inflation data is not making the Fed's job easier. Luna: So, we've got sticky actual inflation and sticky expectations. That's a tricky combination for a central bank that wants to cut rates. Lucas: Right. And there's also the fact that the real rate — the nominal rate minus expected inflation — is actually quite high right now. With the fed funds rate at 3.63 and ten-year breakevens at 2.30, you're looking at a real policy rate north of 1.3 percent. That's restrictive, and it's part of why the Fed has been able to hold steady. But if expectations were to fall, the real rate would rise even further, which could over-tighten. Luna: So, in a weird way, the Fed is hoping that inflation expectations don't fall too much, because that would make policy too tight. Lucas: Exactly. It's a balancing act. And that's why the Fed watches this survey so carefully. Every time a number comes out, the Fed's reaction function shifts a little bit. The market knows this, which is why the Michigan survey can move bond yields on release day. Luna: Let's talk about the mechanics of the survey. How many people do they actually poll? And how reliable is a sample of a few hundred consumers? Lucas: The survey interviews about five hundred households by phone, and it's been running since the 1940s. The sample size is small, but it's designed to be representative, and the methodology has been pretty consistent. The Fed also looks at the New York Fed's survey of consumer expectations, which has a larger sample and different questions. So they cross-reference. Luna: So, if the Michigan survey is noisy, why does the Fed put so much weight on it? Just because it's been around forever? Lucas: Partly, but also because it's the one that markets react to. And the Fed cares about market expectations. If traders think the Michigan number is important, then it becomes important for the Fed to understand why. It's a bit of a self-fulfilling prophecy, but in a different way. Luna: So, is there anything in the recent data that suggests expectations are de-anchoring? Like, is this a warning sign or just noise? Lucas: I'd say it's more noise than signal right now. The five-year ahead number has been remarkably stable around 3 percent for months. It's the one-year ahead that jumps around more. And that's typically driven by gas prices and headlines. If you look at the ten-year breakeven, which is market-based, it's been range-bound between 2.2 and 2.4 percent. So I'd say expectations are still anchored, but they're anchored at a level above the Fed's target, which is a concern. Luna: So, what would push the Fed to actually change its policy stance based on this survey? Is there a threshold or a pattern they're looking for? Lucas: I think they'd want to see a sustained move, not just one month. If the five-year ahead expectation started trending up toward 3.5 percent, and if the ten-year breakeven pushed above 2.5, then you'd start to hear Fed speakers use language like 'unmoored' or 'unanchored.' That would be a signal that they're willing to keep rates high for longer, or even hike again. Luna: And speaking of Fed speakers, we've had a quiet period before the September meeting. But the minutes from the July meeting came out last week, and I think they hinted at some of this concern. Lucas: They did. The minutes showed that several participants mentioned the stability of longer-run inflation expectations as a key factor in their decision to hold rates steady. But they also noted that 'some measures of market-based expectations had moved up slightly.' So that's a direct reference to the breakevens we're seeing. Luna: So, they're watching the same numbers we are. But here's the thing — if expectations are so important, why doesn't the Fed just launch a big communications campaign to try to talk them down? Lucas: Because it's tricky. If the Fed goes out and says 'we're confident inflation will return to 2 percent,' but then inflation stays sticky, they lose credibility. So they have to walk a fine line. They want to project confidence without being complacent. That's why Powell's press conferences are so carefully scripted. Luna: So, it's a communication challenge as much as an economic one. Lucas: Right. And that's something we've touched on in previous episodes, but I think the focus on expectations is a fresh angle. It's not just about the numbers; it's about the psychology. Luna: And that psychology can feed back into the real economy. If people expect higher inflation, they'll spend more now, which actually pushes prices up. So the Fed has to be proactive. Lucas: Exactly. And that's why the Michigan survey is more than just a polling exercise. It's a window into the collective mindset of consumers, and that mindset matters for the path of inflation and for the Fed's decisions. Luna: Well, and if that's the kind of insight you get from our show, you know, we do this every day, and it's ad-free thanks to our listeners. If you find value in these conversations, and if today was worth a coffee to you, you know where to find us — it's buy me a coffee dot com slash fexingo. That's the smallest way to keep this going. Lucas: Yeah, and we really do appreciate it. It's what lets us keep digging into these angles without worrying about sponsors. But back to the topic — one thing I want to bring up is how the Fed actually uses these expectations in its forecasts. They have their own estimates, but they also look at the survey data as a cross-check. Luna: So, the Fed's own projections, like the dot plot, are partly informed by these surveys? Lucas: Definitely. The staff at the Fed run models that incorporate survey expectations, and those feed into the SEP, the Summary of Economic Projections. So when you see the dots shift, part of that is due to changes in inflation expectations. Luna: So, if we see the five-year ahead Michigan number move up next month, we could see some dots move higher in September? Lucas: It's possible. But the Fed will probably wait for a few more readings to confirm the trend. They don't want to overreact to a single data point. That's a lesson they learned from the 'transitory' mistake. Luna: Right, they were burned by that. So, they're going to be cautious. But I still think it's fascinating that something as subjective as a consumer poll can have such a concrete impact on policy. Lucas: It's the human element of economics. At the end of the day, inflation is about people's behavior, and people's behavior is driven by what they expect to happen. The Fed is trying to manage those expectations as much as the actual price level. Luna: So, as we head into the September FOMC meeting, what should we be watching for? Any particular release or comment that could tip the scales? Lucas: I'd keep an eye on the final Michigan reading for August, which comes out at the end of the month. And the next PCE report, which will give us the Fed's preferred inflation measure for July. If those show any surprises, expect the market to react. Luna: And also the jobs report, of course. But I think we've covered that in previous episodes. Lucas: We have. So today, the takeaway is that inflation expectations are the quiet force behind the Fed's decisions. And the Michigan survey is one of the key windows into that force. Keep an eye on those numbers.