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The announcement of another 75 basis point rate hike at last week’s FOMC meeting reaffirmed the Federal Reserve’s unwavering commitment to reducing inflation. One of the key variables the Fed watches to help it determine the path of rates is expected inflation. Inflation can become a self-fulfilling prophecy if consumers start pricing future inflation into their decision-making and businesses start making anticipatory adjustments to their prices and behavior. To combat this, the Fed strives to anchor expectations around a 2% target inflation rate. When long-term inflation forecasts deviate from that 2% target it means inflation expectations are not well-anchored, i.e., people believe that a short-term rise in inflation could lead to higher price levels longer-term.
Inflation expectations have moved further away from the 2% target over the course of 2022, something the Fed recognizes as a potential roadblock in navigating the current inflationary environment. Indeed, Fed Chair Jerome Powell stressed the importance of “expeditiously continuing to raise rates” to “ensure that longer-term inflation expectations remain well-anchored” at the June FOMC press conference.¹ With higher-than-anticipated August CPI figures, however — headline inflation of 8.3% and core inflation that reaccelerated to 6.3% — inflation expectations may remain higher for longer. Headline inflation is moving in the right direction, but core inflation, which remains well above Fed targets, tends to be stickier and may further complicate the Fed’s task. While there are no crystal balls, longer-term inflation expectations will continue to bear monitoring as investors search for potential indicators of a market bottom.
¹ Lee, J., Powell, T., & Wessel, D. (2022, June 27). What are inflation expectations? Why do they matter? The Brookings Institute. Retrieved September 28, 2022.
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