Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Watching Consumer Inflation Expectations
Transcript
- Lucas: So May CPI came in at 4.2 percent annual inflation yesterday. That's the highest print in three years. But the number that might matter even more to the Fed right now is not actually in that report. Luna: You're talking about inflation expectations, right? What people think inflation will be, not what it is today. Lucas: Exactly. The Fed's own research shows that expectations drive actual inflation. If households and businesses start believing prices will keep rising fast, they adjust their behavior — they demand higher wages, they raise prices preemptively — and that becomes a self-fulfilling prophecy. Luna: So the Fed is almost fighting a psychological battle as much as an economic one. Lucas: That's the framework. And right now, the latest New York Fed household survey — that came out last week — showed consumer financial anxiety hitting its highest level since July 2022. People are worried. And when they're worried, they tend to expect higher inflation. Luna: But the actual CPI numbers have been sticky. Core CPI ex food and energy ticked up to 336.1 in May from 335.42 in April. That's not a huge jump, but it's in the wrong direction. Lucas: Right. And the Fed's preferred inflation gauge — the core PCE price index — also crept up in April to 129.6 from 129.32. So you've got hard data showing inflation is not coming down fast, and soft data showing consumers are bracing for more. That's a problematic combination. Luna: And the ten-year breakeven inflation rate — which is basically the bond market's expectation of average inflation over the next decade — ticked up to 2.34 percent. That's still within the Fed's comfort zone, but it moved up. Lucas: It did. And the Fed watches that number closely. But here's the nuance: the breakeven rate is a market-based measure. It can be influenced by liquidity premiums, technical factors, all sorts of stuff. The consumer survey is noisy in a different way — it's psychological, not transactional. The Fed triangulates between them. Luna: So which one does the FOMC lean on more when they're deciding on rates? The hard data or the soft data? Lucas: Historically, the hard data has more weight. But since the pandemic, the Fed has put increasing emphasis on expectations. Chair Powell has said multiple times that anchoring expectations is a key objective. If expectations become unanchored — meaning people stop believing the Fed will bring inflation down — then it becomes much harder to regain credibility. Luna: And credibility is the main tool the Fed has. They can't control global supply chains or energy prices directly. Lucas: Exactly. So back to the May CPI number: 4.2 percent is high, but what the Fed really wants to know is whether that number shifts how people think about the future. The New York Fed survey came out before the CPI print, so we don't yet have a read on how consumers reacted to that specific number. But the trend is concerning. Luna: And we also got the JOLTS data recently — job openings surged to 7.6 million. That's a tight labor market, which puts upward pressure on wages, which feeds into services inflation. Lucas: Right. So you have this feedback loop: tight labor market pushes wages up, higher wages push prices up, consumers see higher prices and expect more of the same, and then they demand even higher wages. The Fed's job is to break that loop, primarily by raising rates to cool demand. Luna: But the Fed funds rate is at 3.63 percent effective as of May. That's down from a peak of over 5 percent last cycle. So they've already cut. But if inflation expectations start to drift, they might have to reverse course. Lucas: That's the tricky part. The Fed has signaled they're in a holding pattern — watching data, waiting for more clarity. But if the May CPI print and the consumer anxiety numbers persist, they might have to tighten again. Not necessarily a rate hike, but they could keep rates higher for longer than markets currently expect. Luna: And on that point — we've been digging into these numbers every week and trying to make sense of them. Quick honest thing: a handful of listeners chip in monthly through buy me a coffee dot com slash fexingo, and that's literally what funds making this many of these episodes. No ads, no sponsors, just people who find this useful. Lucas: Yeah, it's a small group but it makes a big difference. Keeps the whole podcast network running. Anyway — back to the data. So where do we look next for clues on expectations? Luna: The University of Michigan consumer sentiment survey comes out later this month. That has a specific question about year-ahead inflation expectations. That's the one the Fed really watches. Lucas: Exactly. And the New York Fed survey we just referenced is the other key. Both of those are 'soft' data, but they've been pretty good leading indicators. If those numbers start to drift above 3 percent for the one-year-ahead measure, the Fed will take notice. Luna: Right now the New York Fed survey had one-year-ahead expectations at around 3.1 percent in April. That's down from the peak but still above the Fed's target. And with the May CPI print, it's possible that number ticks up again. Lucas: And then there's the longer-term measure — five-year expectations. That's the one the Fed cares about most. If that stays anchored around 2.5 to 2.8 percent, they can tolerate some short-term noise. But if that starts to move, they have to act. Luna: So the question becomes: is the May CPI print a one-month blip or the start of a trend? And are consumers looking through it or reacting to it? Lucas: Right. And that's why the Fed is being patient. They don't want to overreact to one data point. But they also don't want to fall behind the curve. It's a balancing act. Luna: One thing that's different this time versus 2022 is that energy prices are a big driver. The Iran war energy spike pushed gasoline prices up, and that's what consumers feel most directly. But core inflation — excluding food and energy — has been more stubborn. Lucas: Yeah, the core CPI ex food and energy is at 336.1, which is up 0.2 percent month-over-month. That's not accelerating, but it's not decelerating either. Services inflation remains sticky, partly because of housing costs and partly because of labor costs. Luna: So if the Fed is watching expectations, and those expectations are partly driven by gas prices, then the geopolitical situation becomes a factor in monetary policy. That's an uncomfortable place for the Fed to be — they can't control foreign policy. Lucas: They can't. But they can control demand. If energy prices spike and push headline inflation up, the Fed might look through it if expectations remain anchored. But if that energy spike starts feeding into broader price increases — like transportation costs raising the price of goods — then it becomes a problem. Luna: And that's where the household financial anxiety number comes in. The New York Fed survey showed that the share of households expecting their financial situation to worsen a year from now hit the highest level since July 2022. That's a broad-based anxiety. Lucas: It is. And that anxiety can translate into lower spending, which would actually help the Fed by cooling demand. But it can also translate into higher inflation expectations if people think prices are out of control. The Fed has to parse which effect dominates. Luna: So what's your read? Are expectations becoming unanchored? Lucas: I'd say not yet, but the risk is rising. The ten-year breakeven at 2.34 is still within the range the Fed has seen over the past year. The University of Michigan numbers have been around 3 percent for one year ahead. That's above target but not alarming. What would alarm me is if the five-year expectations start moving above 3 percent. Luna: And we'll get that data later this month. So the next few weeks are crucial. Lucas: Yeah. And in the meantime, the Fed is likely to stay on hold. The next FOMC meeting is in July. If the data between now and then shows expectations slipping, they might adjust their forward guidance. But a rate hike seems unlikely unless we see a clear deterioration. Luna: So for listeners, the key thing to watch is not just the CPI number itself, but how consumers and markets react to it. The inflation psychology, as you called it. Lucas: Exactly. The number itself matters, but the story people tell themselves about that number matters just as much.