The Fed is More Fearful of Rising Consumer Inflation Expectations, Preferring to Raise Interest Rates by 75 Basis Points

The Fed is more afraid of rising consumer inflation expectations and tends to raise interest rates by 75 basis points.

To prevent something worse from happening, the Fed is willing to accept the risk of a recession.

Fed officials have signaled that they accept the risk of a recession because they want to prevent what they believe is worse: a change in consumer psychology that could keep inflation high.

Fed Chairman Jerome Powell acknowledged last week that the central bank is increasingly leaning toward a 75-basis-point rate hike, the most aggressive rate hike since the 1980s, and that such hikes increase the likelihood of an economic downturn.

On June 29, Powell said at the European Central Bank's annual economic policy meeting: "Obviously, for the U.S. economy, the Fed's tightening has too big a crotch" risk, but it's not the biggest risk." The biggest risk is the Fed's inability to get prices back to a reasonable level.

The root of the Fed's aggressive tightening of monetary policy is precisely the pessimistic expectations of American households and businesses that inflation will remain high for a long time. To break the "invincible inflation" theory, the Fed must raise interest rates.

The chief financial reporter for The Wall Street Journal, who reports on the Federal Reserve and U.S. economic policy, said the recession is painful and the number of unemployed in the United States will reach 1 million. The lessons learned in the 1970s have made current Fed officials take the situation seriously: after high inflation expectations prevailed, high inflation took root in the U.S. economy for several years as expected; unprecedented high inflation triggered the Great Recession and Great Depression and continued until the early 1980s.

In the early 1980s, then-Federal Reserve Chairman Paul Volcker implemented "shock therapy." The federal funds rate, which once soared to a high of 20%, effectively suppressed inflation but also triggered a recession again in the 1980s. The U.S. unemployment rate reached its peak after the Great Depression of 1929–1933.

Former Fed economist John Roberts said that for the Fed, not being tough enough to raise rates is a bigger mistake than being too dovish. The Fed is going all out to fight inflation, and a big rate hike is the right thing to do. However, it also means that the U.S. The risk of a recession will also rise.

The reopening of economies and economic stimulus from governments have led to increased demand, and rising fuel costs and a stalemate in Russia and Ukraine have disrupted multiple supply chains around the world, further fueling inflation that was already high last year.

Data showed that in May, U.S. consumer prices rose 6.3% from a year earlier. Excluding the volatile food and energy categories, U.S. core CPI prices were still up 4.7%.

When goods and services are in short supply, inflation can go even higher. Fed officials believe that when the U.S. unemployment rate is below a certain natural equilibrium level, a tight labor market will put upward pressure on wages and prices. However, when the unemployment rate is at a natural equilibrium level, inflation will be strongly influenced by public expectations, and this public expectation can be self-fulfilling. If consumers expect prices to be higher in a year, they'll be stocking up sooner rather than later.

For example, John Cochran, a senior fellow at the Hoover Institution in the United States, says, “If you’re a landlord, once you know in advance that prices are going to go up, you will increase your rent." If you’re a worker, once you know in advance that prices are going to go up, you will ask for a raise. In short, in terms of current behavior, people's predictions of the future are crucial.

Based on this, Nick Timiros believes that one of the reasons why the Federal Reserve aggressively raised interest rates by 75 basis points in June was precisely the concern of American consumers about inflation expectations. At the same time, the Federal Reserve also hinted that it may raise interest rates by another 75 basis points at the FOMC meeting on July 26–27.

In 2021, when inflation was just picking up in the U.S. economy, Fed officials were unresponsive due to the misjudgment that "price increases are driven by temporary factors." U.S. inflation has remained subdued since the 1990s, leading the Fed to believe that inflation expectations will also stabilize or even anchor around its 2 percent target.

Economists have a set of measures that track inflation expectations. They include consumer surveys, bond market tools, and econometric models. Many indicators suggest that while inflation expectations have risen, they remain within recent historical ranges.

Nick Timiros summed up the top three reasons Fed officials are nervous about consumer inflation expectations: First, the economic literature suggests that when inflation is low, people pay less attention to price changes. However, once the price rises enough, it can trigger consumers' attention, which can affect their long-term expectations.

Second, in one piece of literature, senior Fed economists have highlighted the divergent academic understanding of how inflation expectations evolve. John Cochran even suspects that the stability of inflation expectations induces some economists to believe that what appears to be an anchor of "2%" inflation expectations is difficult to beat.

"As far as we (Hoover Institution) know, 'wind' hasn't been around for a long time."

Third, the U.S. economy has suffered multiple blows since the outbreak. In the early stages of the epidemic, supply chain disruptions and unemployment occurred in large numbers. In the Trump era, the Federal Reserve's loose monetary policy led to a surge in demand, which further exacerbated the bottleneck of restarting the US economy. This spring, the Russian-Ukrainian conflict sent energy, food, and commodity prices soaring.

Current data suggests that long-term U.S. consumer inflation expectations remain stable.

Powell said, “The risk is that, under multiple shocks, consumers will gravitate towards high inflation expectations, which the Fed is trying to prevent." If it were only assumed that these long-term expectations would remain stable indefinitely with persistently high inflation, it would be "bad risk management."

Some economists are seeing worrying signs. Ricardo Reis, an economist at the London School of Economics, found that before the broader rise in U.S. inflation expectations in the 1970s and 1980s, the percentage of U.S. households that expected inflation to rise even when the median U.S. household did not expect it. Increase.

Last month, a New York Fed survey of consumers showed that short-term inflation expectations among U.S. consumers rose, and the distribution of U.S. households' long-term inflation expectations was more diverse than in the past.

Robert Dent, the senior U.S. economist at Nomura Securities, said: “The widening distribution of U.S. households’ long-term inflation expectations suggests that inflation expectations have shifted and may be more sensitive to recent data." I fear this is the start of a rise in long-term inflation expectations or even a "de-anchor" from the Fed’s 2% inflation target.”

At a meeting in May, John Cochran presented a simple analysis that highlighted the cost of misjudging any shift.

John Cochran said: “If U.S. households’ long-term inflation expectations do not rise, the Fed will likely raise the federal funds rate to between 3% and 4% in the next few years, thereby reducing inflation to its target (2%) in the next few years." "No doubt, the economy will remain under pressure during this period; if U.S. households expect the current high inflation to continue, only a fed funds rate as high as 9% will save the day.”

Powell has said the Fed will not slow down until there is "compelling" evidence that inflation is fading. Some economists worry that the Fed is running out of steam. Over time, rate hikes affect the economy. As such, inflation data is also a lagging indicator of the impact of Fed rate hikes.

U.S. Treasury yields fell last week. That bodes well for investors, who believe that a recession could see investors welcome a rate cut in 2023 after sharp hikes this year.

Neil Dutta, an economist at research firm Renaissance Macro, said: "The market is reacting to the Fed's entering policy error territory, and those reactions are painful."

Other economists said Powell had no choice but to be tougher.

Former New York Fed President William Dudley said, "My view is that Powell can choose to raise rates now or he can choose to procrastinate." And if you procrastinate now, the work will be harder later. I think Powell must know that. "

In this scenario, once the US economy shrinks and unemployment rises, it will make Powell's future policy direction difficult. The Fed's sharp water withdrawals plunged the economy into a sharp downturn and eventually prompted the Fed to cut interest rates in 1975. Although inflation did drop after that, it remained stable at high levels and continued to climb over the next few years.

Peter Hooper, head of global economic research at Deutsche Bank at the time, said: "Throughout the 1970s, the Fed had nothing to do with high inflation."

Powell insists he won't repeat the mistakes of Arthur Burns, the "worst Fed chairman ever" in the 1970s. Last week, Powell answered a question about "what data points in the U.S. economy he will be watching to see if inflation expectations are rising." Powell argues that data points do nothing to judge whether inflation expectations have risen or not.