Federal Reserve Chairman Jerome Powell is pinning his hopes of stopping the U.S. economy from overheating on a variable that a former colleague called “the most significant unobservable of all:” inflation expectations.
In recent public appearances, Powell has argued that the Fed can countenance a fall in joblessness to an almost 50-year low without triggering an inflationary surge in large part because Americans believe the central bank will keep prices under wraps. “The key is the anchored expectations,” he said last week.
The problem is that it’s not easy to divine what inflation beliefs are and how they might change. What’s more, there’s no measure of where companies -- arguably the most important players in setting prices -- expect the cost of living to go. That makes Powell’s focus on price expectations a potentially risky move as the Fed gradually raises interest rates.
“The concept of inflation expectations is quite under-theorized and hard to pin down empirically,” Powell’s former Fed colleague, Daniel Tarullo, said in a speech last October.
Janet Yellen, Powell’s predecessor as Fed chair, also understood the limitations: “Economists’ understanding of exactly how and why inflation expectations change over time is limited,” she said in a speech in September 2017.
If inflation were to get out of control, that would be bad news for investors. In recent days, the stock market has been rocked by a rise in Treasury bond yields primarily driven by the economy’s strength -- not by expectations of faster inflation. Yields could march higher still if rising wages and surging oil prices trigger a spike in consumer prices, forcing the Powell Fed to rethink its gradual strategy for containing inflation.