International Forecaster Weekly

STATE OF THE UNION IS SAD As Inflation Expectations Hit Record High

Morale among American consumers —I prefer "people"— worsened earlier this month by generation-high inflation and a major war in eastern Europe.

The latest University of Michigan survey showed overall consumer sentiment falling in March for the fifth time in the last six months to an almost 11-year low.

These days, on top of a dreadful and frustrating two-year Covid malaise, everyday Americans are asking, "Why does anything matter?"

The Michigan numbers show the public mood souring over inflation worries have totally surpassed other indicators that show an otherwise strong (albeit volatile) economy.

The mood also bodes particularly ill for members of Congress and state houses hoping not to be, well, unelected.

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Inflation Fed

Guest Writer | March 15, 2022

By Dave Allen for Discount Gold & Silver

Morale among American consumers —I prefer "people"— worsened earlier this month by generation-high inflation and a major war in eastern Europe.

The latest University of Michigan survey showed overall consumer sentiment falling in March for the fifth time in the last six months to an almost 11-year low.

These days, on top of a dreadful and frustrating two-year Covid malaise, everyday Americans are asking, "Why does anything matter?"

The Michigan numbers show the public mood souring over inflation worries have totally surpassed other indicators that show an otherwise strong (albeit volatile) economy.

The mood also bodes particularly ill for members of Congress and state houses hoping not to be, well, unelected.

Fed Hopes to Put a Brake on Inflation

The Federal Reserve's policymaking Open Market Committee meets today and tomorrow and will almost certainly raise its benchmark interest rate by a quarter of a percentage point. 

It will be what Neil Irwin calls a “first baby step in what looks to be a long and [grueling] path” to lower prices.

How the Fed navigates the economic tightrope will determine whether the next couple of years feature a steeper recession, ongoing sky-high inflation, neither or both.

Irwin believes that with CPI inflation at the 8% mark (it’s actually closer to 13%-16%) and headline unemployment below 4% (it’s actually over 7% -- and as much as 25%, according to ShadowStats.com), the Fed is, by any historical standard, way behind the 8 ball in raising rates.

Its daunting dilemma is how to fix that without actually crashing the economy—a task complicated by the Russia’s invasion of Ukraine and new pandemic lockdowns in China, our biggest trading partner.

Fed Chair Jerome Powell is no doubt betting on "neither." But getting there is looking like a hairy challenge, given how far the Fed’s current policy is from what we'd typically expect to act as a brake on growth and inflation.

In fact, it’s now one year since the Fed started falling behind the curve on aligning monetary policy with economic conditions on the ground. 

Consider this timeline: In December 2020, with the economy still in shambles from nationwide shutdowns, Fed officials forecast they'd keep interest rates near zero through at least the end of 2023.

Between then and March 2021, Congress passed a bipartisan $900 billion pandemic aid package, Democrats captured control of the Senate with two big victories in Georgia special elections, the Biden administration's $1.9 trillion rescue plan passed, Covid vaccines became widely available.

And inflation started picking up—fast and furious.

But the outlook for Fed policy didn't change at the March 2021 meeting, despite those dramatic shifts in the outlook for fiscal policy and public health.

Is Past Prologue?

Fed officials say they didn't want to repeat their mistake of the 2010s, when they hastily tightened, slowing the jobs recovery prematurely. 

With armchair quarterbacking firmly in control, that left the Fed stuck in a position of super-easy money even as GDP surged and inflationary pressures skyrocketed.

Now, the Fed is on the verge of the first step toward tighter money. 

At the conclusion of this week’s meeting tomorrow afternoon, FOMC members will update their interest rate forecasts. And that will tell us where the consensus lies on how fast they can—and probably will—move.

The Fed believes the longer-term "neutral rate," which neither stimulates nor slows the economy, is around 2.5%. It would take a total of 10 quarter-point moves (or 5 half-point moves) this year just to reach that.

Economists and WallStreeters are expecting less than that, maybe 6, or at most 7, rate hikes this year with perhaps more in 2023 as needed.

Powell has aimed to move cautiously in his tightening campaign, in part to avoid adding more uncertainty in an unsettled time. The tradeoff is that the Fed is now playing catch-up.

Inflation Expectations Are Grim

Both everyday Americans as well as the honky tonks at too big to fail banks have rising expectations for inflation in what policy wonks worry could be the start of a self-fulfilling prophecy.

A market-based reading of inflation expectations — often referred to as a “5-year breakeven”—shot to the highest level on record this week.

This number is the result of comparing the yields on Treasury bonds to a separate Treasury that's protected against losses from inflation (aka TIPS).

At its current level of 3.5 percentage points, it suggests that investors now expect inflation to average roughly 3.5% a year for the next five years.

Separately, the latest University of Michigan survey shows shorter-term inflation expectations among American consumers rising to their highest level since 1981.

In theory, Economics 101 says there’s a strong psychological component to inflation. In other words, when people expect prices to rise, they tend to behave in ways that actually cause prices to rise.

Here’s how that theory works: First, workers expect higher prices. Then, they ask for higher wages. Employers raise wages but need to pay higher labor costs as a result.

Thus, employers raise prices of their products. Workers see higher prices. Pass Go and repeat the cycle above.

The Fed—and other central bankers around the world—will view this recent rise in inflation expectations as another reason to proceed with rate increases to start the braking.

Beware this Ide of March: as the state of the union saddens and resigns itself to higher prices, let the screeching begin!