Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use Inflation Expectations Surveys
Transcript
- Lucas: The University of Michigan Survey of Consumers for July 2026 came out this morning — one-year inflation expectations at 3.2 percent, five-year at 2.9 percent. That five-year number is worth pausing on. Luna: Because it's not moving back toward the Fed's 2 percent target the way policymakers hoped. Lucas: Exactly. The five-year expectation has been stuck between 2.8 and 3.1 percent for about a year now. And this matters because inflation expectations are arguably the most important variable in modern central banking. Luna: More important than the actual inflation print? Lucas: In a way, yes. The theory goes that if households and businesses expect 3 percent inflation, they'll set prices and wages accordingly — and that expectation becomes self-fulfilling. So central banks don't just fight current inflation; they fight the inflation people expect. Luna: That's why they spend so much money on surveys. Lucas: Right. The Fed subscribes to multiple surveys, but the two most watched are the University of Michigan Survey of Consumers, which gives us household expectations, and the Survey of Professional Forecasters run by the Philadelphia Fed. Then there's the market-based measure — the five-year, five-year-forward breakeven rate from TIPS. Luna: And those three can tell very different stories. Lucas: Exactly. Right now households are more worried than professionals. The SPF for Q2 2026 had long-run expectations at 2.3 percent, but Michigan's five-year is at 2.9. That gap matters because the Fed tends to weight professional forecasts more heavily, but if household expectations keep drifting, that's a credibility problem. Luna: And the bond market? The breakeven rate? Lucas: The five-year-forward breakeven is around 2.4 percent as of this week. So the market is somewhere between households and professionals. But here's the thing — if you look at the 1970s, the Fed lost control of inflation precisely because expectations became unanchored. People expected 6, 7, 8 percent and acted accordingly. Luna: Paul Volcker had to push rates to 20 percent to break that psychology. Lucas: That's the textbook example. And the lesson central banks took from that era is that you have to anchor expectations preemptively. That's why the Fed talks so much about its 2 percent target — it's not just a number, it's a communications tool designed to shape what people believe. Luna: So when the Michigan survey shows 2.9 percent, the Fed sees a red flag. Lucas: Absolutely. Especially because the Michigan survey asks consumers about their own experience — gas prices, groceries, rent. Those are visceral. If people feel inflation running hot, they don't care that core PCE is at 2.6. They act on what they feel. Luna: And that's where the ECB has an interesting approach. They launched their own Consumer Expectations Survey a few years ago. Lucas: Right, the CES. It's a monthly survey of about 20,000 households across the euro area. The ECB uses it to track not just point expectations but uncertainty and disagreement. For example, in the June 2026 release, median one-year expectations were at 2.8 percent, but the interquartile range was wide — from 1.5 to 5 percent. That dispersion tells you people are confused. Luna: Confused expectations are almost as bad as high expectations. Lucas: Exactly. Because if people can't agree on where inflation is heading, they might hedge — raise prices just in case, demand higher wages just in case. That kind of behavior can become self-reinforcing. Luna: So what can a central bank actually do when expectations start drifting? Just talk more? Lucas: Talking is part of it — forward guidance, press conferences, speeches. But eventually you need action. If the Fed wants to bring Michigan expectations down from 2.9, it probably has to keep rates higher for longer than the inflation data alone would dictate. That's the cost of losing credibility. Luna: Speaking of credibility — this show stays ad-free because of listeners who choose to support it. If walking through the economy with us has made something click, you can help keep it that way at buymeacoffee.com/fexingo. Lucas: It's a small gesture that goes a long way. And we really appreciate it. Now — back to the numbers. Let's look at what the five-year-forward breakeven actually tells us about market thinking. Luna: You mentioned it's around 2.4 percent. That's above the Fed's target. Lucas: It is. And the spread between the breakeven and the Fed's target is often called the 'inflation premium' — the compensation investors demand for the risk that the Fed doesn't hit its goal. That premium has been slowly widening since March 2026. Luna: What drives it? Lucas: Several things. One is the resilience of the labor market. Another is tariff policy — businesses are passing on costs. But also, there's a structural argument that globalization kept inflation low for decades, and that era might be ending. If that's true, the neutral rate of interest might be higher too, which means the Fed's job is harder. Luna: We talked about the neutral rate in Episode 114. Lucas: We did. And that episode fits here because if the neutral rate has risen, then the current policy rate might not be as restrictive as the Fed thinks. And if policy isn't restrictive enough, expectations stay elevated. Luna: So there's a feedback loop. Expectations affect actual inflation, which affects policy, which affects expectations again. Lucas: Exactly. And that's why central banks watch these surveys so obsessively. The Bank of Japan, for example, has been fighting deflationary expectations for decades. They only recently got inflation above 2 percent, and they're terrified that expectations will slip back. Luna: How do they measure expectations there? Lucas: The Bank of Japan runs its own Opinion Survey on the General Public's Views and Behavior. As of June 2026, one-year inflation expectations were at 2.1 percent — barely anchored at their target. Compare that to the Riksbank in Sweden, which has had a 2 percent target since 1995, and their survey expectations have been rock solid around 2 percent for years. Luna: So credibility is built over decades. Lucas: And can be lost in months. That's the scary part. The Fed is in a delicate spot right now. The Michigan five-year number at 2.9 is not catastrophic, but it's stubborn. If it ticks up to 3.1 or 3.2 in the next few months, the FOMC will have to respond. Luna: And the market is already pricing in a higher probability of a rate hike at the September meeting. Lucas: According to CME FedWatch, yes. But here's a nuance — the market-based measure, the five-year-forward breakeven, has been a bit more stable. It suggests the bond market isn't panicking yet. The divergence between household and market expectations is actually an interesting signal. Luna: What does it mean? Lucas: It could mean that households are reacting to recent high prices — recency bias — while investors are looking through the cycle. Or it could mean that the bond market is too complacent. The Fed has to decide which interpretation to believe. Luna: And that decision shapes policy. Lucas: Exactly. If they lean on the household survey, they might hike. If they lean on the market, they might hold. This is the art of central banking — you have to weigh imperfect signals and act anyway. Luna: So what's your read on the July data? Lucas: I think the Fed will be concerned but not alarmed. The Michigan number is stable month-over-month — it's not accelerating. But the fact that it's stuck at 2.9 is a warning. I expect the July FOMC statement to emphasize that the committee remains 'highly attentive to inflation risks' and possibly add a line about monitoring expectations. Luna: That would be a subtle dovish to hawkish shift. Lucas: Very subtle. But that's how the Fed communicates — through commas and adjectives. They know the market parses every word. And they want to signal that they haven't forgotten the 1970s. Luna: One last thing — the Bank of England's survey. They use the Inflation Attitudes Survey, which has a long history. Lucas: Good point. The Bank of England's survey goes back to 1999. In the May 2026 wave, median one-year expectations were at 3.1 percent, down from 3.4 a year earlier. That's improvement, but still above target. And the Bank has been cutting rates cautiously because they worry about second-round effects from wage growth. Luna: So every central bank is watching the same indicators, but the nuances differ. Lucas: Exactly. The common thread is that inflation expectations are the canary in the coal mine. If they stay anchored, the central bank can afford to be patient. If they drift, you have to act fast. Right now, the canary is still alive, but it's not singing. Luna: That's a great way to put it. Thanks, Lucas. Lucas: Thanks, Luna. Next episode we'll look at how central banks use the Taylor Rule in practice — with a specific example from the current cycle.