Fed May Be Losing Control of the Inflation Narrative
The Fed appears to be losing control of the inflation narrative and is now at risk of inflation expectations becoming unanchored after all of this time. The latest University of Michigan and Conference Board data showed that consumer inflation expectations rose dramatically in February. The University of Michigan saw the 1-year inflation expectation increase to 4.3% from 3.3%. Meanwhile, the conference board's consumer confidence 1-year inflation expectation rose to 6% from 5.2%. Since 1990, there have only been a handful of times when the inflation measures jumped this much in one month and, more importantly, to levels that are this high. The University of Michigan's long-term inflation outlook was the most damaging. It jumped to 3.5% in February, its highest reading since April 1995 and, more importantly, a new cycle high. It is higher now than in June and July 2022 when inflation was much higher. At this point, consumers not only expected inflation to remain elevated over the short term but also beginning to expect it to remain high for some time to come. The recent surge in consumer-based inflation expectations follows what we have seen from market-based inflation swaps, which have been trading higher since bottoming in early September. They have all risen back to the upper end of their trading ranges, which have been in place since the beginning of 2023. This is somewhat problematic for the Fed because, at this point, inflation expectations should not be rising, especially when it seems that monetary policy is still supposed to be restrictive. But in reality, rising inflation rates and rising inflation expectations coupled with Fed rate cuts have actually made policy more dovish. This is where the danger lurks because if expectations continue to increase, policy will continue to ease. The more policy eases, the more likely it is that interest rates will get stuck at these higher levels, or worse, the Fed will be forced to go back and start hiking again. Once consumers expect inflation to run at a higher rate, those expectations will allow businesses to pass on those higher prices more easily.
