After another tumultuous week in the US, Federal Reserve chair Jay Powell was sanguine in a speech on Friday, saying the US economy remained “in a good place” despite “elevated levels of uncertainty”.
If this was an effort to reassure markets, it did not work. Fears of a US recession have not abated, with even President Donald Trump not dismissing the possibility, and equities took another tumble on Monday. Is the US headed for recession? Email your thoughts: joel.suss@ft.com
Looking through tariffs?
A primary concern for households and businesses is the stop-start nature of Trump’s trade wars. Are import duties going to apply to the US’s closest trading partners? Nobody knows, or perhaps can know, given the capricious nature of the commander-in-chief.
The Fed is, at least outwardly, less worried about tariffs. Speaking on February 17, Fed governor Christopher Waller said “any imposition of tariffs will only modestly increase prices and in a non-persistent manner. So I favour looking through these effects when setting monetary policy.”
On Friday, Powell noted the “textbook” view of looking through a one-time increase in prices, but did suggest why reality might differ: “If it turns into a series of things . . . if the increases are larger . . . what really would matter is what’s happening with longer-term inflation expectations.”
Consider several rounds of impending tariffs ostensibly to come, all at different dates — Mexico and Canada, aluminium and steel, reciprocal tariffs, tariffs on the EU. Consider also retaliations such as the 25 per cent surcharge for Ontario electricity exports, in addition to threats of cutting them off altogether. Perhaps we might check off “a series of things” and “larger” increases.
Great expectations
What about inflation expectations?
In his remarks, Powell noted that “some near-term [inflation expectation] measures have recently moved up. We see this in both market and survey-based measures, and survey respondents, both consumers and businesses, are mentioning tariffs as a driving factor.”
But, resonating with the generally optimistic tone of his speech, Powell added: “Most measures of longer-term expectations remain stable and consistent with our 2 per cent inflation goal.”
This is true when taking a first look at long-run inflation expectations. But, worryingly for the Fed, a more careful examination of the expectations distribution is flashing red.
Median long-term inflation expectations over five years from the University of Michigan’s consumer survey is in line with Powell’s message of “stable and consistent”. But measures of dispersion — or disagreements between households — have not re-anchored back to the pre-pandemic norm and are spiking again.
This is driven by the right tail of expectations. Since mid-2024, 10 per cent or more of respondents expected annual inflation to average an extreme 15 per cent or more over the next five years. By contrast, the average proportion was less than 1 per cent in 2019. Uncertainty (the proportion of those responding that there will be inflation but unsure of how much) has also shot up recently.
This sharp move is partly an artefact of the Michigan survey moving to online responses only from July 2024 — answering by phone results in a lower proportion of extreme inflation estimates (perhaps due to social desirability bias, where talking to someone directly makes you answer differently). It might also partly reflect partisanship biases, which are large in the Michigan survey.
But only partly. An analysis of just the web-based respondents from 2017 onwards reaches the same conclusion: “Long-run expectations have risen in recent months and are elevated relative to the two years pre-pandemic, but remain below peak readings during the post-pandemic inflationary episode. They exhibit substantial uncertainty, particularly in light of policy changes under the new presidential administration.”
Widening disagreement and uncertainty about where inflation is headed in the long term also shows up in the New York Federal Reserve Board’s survey of consumer expectations, even as median expected inflation is back to normal.
Let’s deal with some possible objections. Household surveys elicit the average Joe’s inflation expectations, and your average Joe may have very foggy understanding of inflation, or may overweight certain items in their own consumption basket. Professional forecasters are unsurprisingly much less dispersed in their long-run estimates.
But household inflation surveys capture wider society’s inflation beliefs, and households act on their beliefs about inflation, no matter how far it deviates from “rational”.
US exceptionalism?
Elevated divergence of expectations is not just an American phenomenon — data from Europe also shows levels that have not yet normalised.
Bank of England rate-setter Catherine Mann pointed to the fatter right tails of the UK expectations distribution in a speech last week. More than 20 per cent of respondents to the BoE’s inflation attitudes survey think prices will go up by 5 per cent or more in five years’ time. This is higher than the proportion of respondents anchored at the 2-3 per cent range (roughly 15 per cent), and relative to a 2015-2019 average of roughly 13.5 per cent.
It’s not just households skewing higher. In the Eurozone, a thick right tail of inflation expectations is evident in a survey of firms. Long-run expectations have also become more strongly correlated to short-run expectations, suggesting that the re-anchoring process following the post-pandemic inflation surge is not yet complete.
Dispersion and uncertainty
Higher inflation disagreement does not bode well for a Fed that hopes to “look-through” tariff price effects. For one, inflation dispersion is a good predictor of future inflation, as higher expected inflation becomes self-fulfilling.
Mann argued that “keeping track of the tails matters”. She also presented evidence that large inflation shocks mean “expectations formation becomes more backward-looking”.
And It’s not just households that take time to get over an inflation shock. A recent working paper corroborates this story using implied inflation expectations derived from financial markets. The authors find the 2021-24 high-inflation episode has left “scars” evidenced by “persistently elevated probabilities of a future inflation disaster”.
Inflation uncertainty also matters, and perhaps more than dispersion. Some experimental work shows that higher uncertainty led to lower consumption of durable goods, and portfolios comprising safer assets. Other work shows how inflation uncertainty can lead to a drop in investment and industrial production.
Add growing inflation uncertainty on top of the other sources of uncertainty the Fed and other central banks need to be wary of.
Strong and credible communication can help reduce uncertainty and lower inflation disagreement. But keeping inflation expectations anchored depends on central bank credibility, which depends heavily on central bank independence, both in law and practice.
As concern mounts about political interference at the Fed, expectations may disperse further. The required policy response to tariffs may need to veer far from the textbook.
What I’ve been reading and watching
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Anticipating my question at the top, Tej Parikh has a nice chart-filled piece arguing that the US economy is heading for a recession.
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It is not common for former central bankers to become political leaders, but that’s just what former Bank of Canada and Bank of England governor Mark Carney has accomplished after winning the leadership election for the Canadian Liberals. Ilya Gridneff has an excellent profile.
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The Atlanta Fed’s GDP nowcast showing a sharp contraction in the US economy this quarter caused a stir. Over in Alphaville, Valentina Romei and Robin Wigglesworth dig into the details and uncover the main culprit — “a truly massive surge in US gold imports”. The “gold adjusted” nowcast is for small, yet positive growth of 0.4 per cent.
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The Economist digs into its archives to show how Donald Trump’s tariffs are a throwback to the 1930s.
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Daniel Susskind writes how the UK Office for Budget Responsibility has become “the ultimate arbiter of whether the government’s plan to achieve its central mission — more economic growth — is the right one”.
A chart that matters
As if signs of the inflation anchor slipping was not worrying enough for the Fed, there are some early indications of supply chain worries. Negative sentiment in the Fed’s own beige book about supply chains spiked in March (left panel), although levels are still far below the pandemic. US corporates are also increasingly mentioning supply chain risk in earnings calls (right panel).
