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How Your Inflation Outlook Moves Interest Rates

December 15, 2021 By Jeremy Jones, CFA

By Yuriy Kulik @ Shutterstock.com

Is it all in your head? No doubt some economists and politicians wish it were, but even though inflation is real, how you think about it may have an effect on its duration. Nick Timiraos and Gwynn Guilford report in The Wall Street Journal:

Supply-chain disruptions, labor shortages and climbing oil prices have pushed inflation to a 39-year-high. But attention is now focused on another variable: Do people think inflation is here for a while?

Because people’s expectations can factor into inflation, the answer plays a critical role in determining how the Federal Reserve and the administration manage the rising numbers—and how soon and how much the Fed will raise interest rates.

Psychology around inflation is hard to gauge. Inflation hasn’t been a broad concern since the 1990s, making it trickier to pinpoint Americans’ feelings. Economists disagree on how to interpret polls and indicators in their search for signs of a wage-price spiral, where workers demand higher wages, which drives up prices, leading workers to expect rising inflation and continued increases in wages, and so on.

In November, 7% of respondents told Gallup that inflation was the country’s biggest problem, tied for the highest percentage since 1986. Inflation now figures prominently in labor disputes. Last week, cereal maker Kellogg Co. said that a majority of its U.S. workers had voted down a proposed five-year contract that included a one-time 3% wage increase plus an annual cost-of-living adjustment, capped at $3 an hour, for the rest of the five-year contract. Consumers expect prices will rise at an annual rate of 4.9% over the next year, according to a University of Michigan survey released Friday, matching the survey’s highest level since 2008.

Psychology is one reason the Federal Reserve is likely to signal a faster end to bond-buying and a quicker start to raising interest rates at its meeting this week. “This is about well-anchored inflation expectations,” said Fed Vice Chairman Richard Clarida at a question-and-answer session at the Cleveland Fed two weeks ago. “Getting actual inflation down close to 2% is going to be an important part of keeping those expectations anchored.”

The run-up in inflation this year, to 6.8% in November, has ignited a debate among economists about how to measure inflation expectations. Many argue that long-term expectations are more predictive of behavior than one-year expectations, which are strongly influenced by current prices, such as for gasoline. On that front, they say evidence is more reassuring: Expectations for inflation over the next five years was 3% in December, according to the University of Michigan survey, up 0.5 percentage point in the past year but not much above the average of 2.8% from 2000 to 2019.

Read more here.

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Jeremy Jones, CFA
Jeremy Jones, CFA, CFP® is the Director of Research at Young Research & Publishing Inc., and the Chief Investment Officer at Richard C. Young & Co., Ltd. Richard C. Young & Co., Ltd. was ranked #5 in CNBC's 2021 Financial Advisor Top 100. Jeremy is also a contributing editor of youngresearch.com.
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