Inflation expectations from the New York Fed, actual inflation from the BLS and BEA, chart by MishChart Notes

Inflation Expectations Inflation expectations are elicited using the following two-stage format. Respondents are first asked: “Over the next 12 months, do you think that there will be inflation or deflation? (Note: deflation is the opposite of inflation)”. Depending on their response to this, they are next asked for a point estimate: “What do you expect the rate of [inflation/deflation] to be over the next 12 months? Please give your best guess”.

We prefer asking respondents for “inflation” because our prior research in the HIEP suggests that the way the Michigan Survey question is phrased induces mixed interpretations, with some respondents thinking about specific prices they pay and others thinking about the overall rate of inflation.

We found that asking about the rate of inflation directly reduces ambiguity in question interpretation and yields, we believe, more reliable, more inter-personally comparable responses. Moreover, it is consistent with the concept of forward inflation expectations of interest to central banks.

The survey of consumer expectations is monthly. It covers expected wages, expected inflation, home buying intent, job intent, home price expectations, etc. The focus in this post regards inflation expectations.PCE vs CPIThe PCE price index is the Fed’s preferred inflation index. PCE includes items paid for on behalf of consumers, notably Medicare and Medicaid.The CPI counts only items paid directly by the consumer.Neither counts home prices and this is very important as explained later.What is Inflation?Some people view inflation as an increase in money supply. For those who cling to that view, we are in a period of deflation now because money supply has been shrinking at the fastest pace in history.Others define inflation and deflation as who much the dollar buys. This logically includes home prices.The Fed views inflation through the eyes of PCE and CPI. In other words, the Fed thinks consumer prices are what constitutes inflation.I disagree, and you probably disagree too. However, economists in general do agree with this misguided idea.A Difference of OpinionMy opinion of what constitutes inflation does not matter, nor does yours, unless you are part or the Fed.The Fed believes inflation expectations matter, as noted above, and so do a surprising number of people who I thought would know better.This post is in response to views of two people on Twitter that I highly respect. The first is Bob Elliott, Co-Founder, CEO & CIO of Unlimited Funds and Head of Ray Dalio’s Research Team at Bridgewater Associates. The second is Bill Fleckenstein at Fleckenstein Capital. I follow both on Twitter.I bring them into the discussion because of a long Tweet thread discussion over the past few days that is the reason for this post. Here is a Twitter Recap to discuss.Again, I respect both Elliott and Fleckenstein but I strongly disagree with them on this topic.Elevated Expectations and My Response

Why wouldn’t inflation expectations matter? Think there are lots of common sense planning activities where it would have an effect.

For instance do you think it’s relevant for wage negotiations? Or contract negotiations that include annual step ups?

Really anything that…

— Bob Elliott (@BobEUnlimited) November 28, 2023
Bob Elliott: “Elevated consumer inflation expectations despite big disinflationary pressures recently (oil, cars, goods) adds evidence to the Fed’s concern that inflation isn’t beat. University of Michigan and other surveys show expectations have not come down nearly as much as measured inflation.” Mish: “Seriously @BobEUnlimited please tell me how inflation expectations can possibly matter.” Bob Elliott: “Why wouldn’t inflation expectations matter? Think there are lots of common sense planning activities where it would have an effect. For instance do you think it’s relevant for wage negotiations? Or contract negotiations that include annual step ups?” Mish: “Demographics and labor shortages explain bargaining power of workers now, not belief in expectations! Workers want wages to match PRIOR rises in expenses, not predictions of where things are headed.“ UAW President Shawn Fain made this comment in October: “In the past four years, the average price of a new car is up by 30% and more. Those profits are not passed on to the workers. Instead, they went straight to the pockets of shareholders and corporate executives.” In general, Fain’s comments refer to past inflation, how much prices have risen and how little share union members received. I certainly agree with Bob Elliott regarding future inflation. The UAW got an enormous wage hike, spread out over several years. And this is happening at other unions all over the country. Unless productivity rises to match, these are huge inflationary pressures. But actual inflation is the cause of wages increases, not expectations. Fleckenstein Chimes In

“Expectations mattered in the 70s and 80s for sure”

Did they? How? Did people react to higher prices or expectations of higher prices.

A Fed study and common sense says you are wrong. Belief in ridiculous economic theory is strong!https://t.co/Ya14wOYaaw

— Mike “Mish” Shedlock (@MishGEA) November 28, 2023
Buying In Advance 

Bill, do you double up on rent? Food? Gasoline? Clothes? Natural Gas? Stoves, Refrigerators? What!

Do you hold off buying phones other than a month or so?

If your shoes are worn out, do you go shoeless if you think there’s a sale coming? Buy in advance if you think up?

— Mike “Mish” Shedlock (@MishGEA) November 28, 2023
Fleck dismissed the study without reading it.Fleck: “The fed study? like they know anything. expectations impact behavior, it’s human nature, and it causes double ordering and ” buy in advance” at times.“Me: “Bill, do you double up on rent? Food? Gasoline? Clothes? Natural Gas? Stoves, Refrigerators? What!”

Wonderful Bill.

What percent of the CPI are computer chips?

My rent and shoe analogies are only silly to those who fail to think properly.

It is precisely because expectations do not matter to so much of the CPI that inflation expectations do not fuel inflation!

— Mike “Mish” Shedlock (@MishGEA) November 28, 2023
Fleck : “First of all you cannot double up on rent”.The irony of his comment is that it proves the point I was making.Components of the CPIBy my calculation, at least 80 percent of the CPI is inelastic.People will not double up on rent in advance if they think rent will go up. Similarly they will not double up on gasoline, medical operations, etc.People can stock up on food, if they have a freezer, as I recommend. If so, they stock up on sales prices (i.e. the price has come down). People do not generally stock up at the highest prices expecting still higher prices. And where would they store it anyway? A freezer only holds so much.Do people buy two cars if the price is going up? Take out extra prescriptions?Everything ElsePlease think about “Everything Else”.That category includes refrigerators, TV,s, landscaping, vacations, etc., some of which are elastic demand items and some not. For example, you buy a refrigerator when you need one and then don’t ever double up no matter what your expectations.Among elastic items, do people take two vacations this year and none the next if the cost will be higher next year?So, expectation proponents, please tell me what the hell people will stock up on at high prices simply because they expect higher prices next year. Then tell me what percent of the CPI that is.The answer, of course, is something very close to nothing.The Lead ChartI created that chart yesterday with the new release of the PCE price data.I have used a similar chart before but I made a key improvement by shifting expectations to match what happened.For ease in reading, here is the chart again.Inflation Expectation Key Ideas

Inflation Expectations are a Lagging IndicatorFor the second key idea, please look at the right side of the chart. It shows inflation expectations are a lagging indicator!When year-over-year inflation hit 9.1 percent, the point expectation was 5.5 percent. Then, despite falling year-over-year inflation, expectations kept rising, topping at 8.5 percent eight months after year-over-year inflation really did peak. With the expectation at 8.5 percent, year-over-year the CPI was 5.0 percent and PCE 4.4 percent.You might object that the PCE and CPI are not good measures of inflation. Bill replied to Bob Elliott with “Don’t get me started on hedonics.”I agree on both counts. But the Fed is making decisions using the PCE and CPI which do not include housing. Housing is far more important than hedonics.Home Prices Hit a New Record High According to Case-ShillerExisting home prices hit a new record high in September. Please than the Fed.National and 10-city prices from Case-Shiller, BLS for other data, chart by MishThe chart is a direct result of Fed QE policy, suppressing interest rates and creating asset bubbles.For discussion, please see Home Prices Hit a New Record High According to Case-Shiller, Thank the FedIf the chart does not represent inflation, then what is it? An egg salad sandwich? Well, no, not that, because an egg salad sandwich would be in the CPI.Index Change Since 2020

The important point is home prices have risen nearly 28 percentage points more than OER and rent. Supposedly that does not count because homes are a capital expense, not a consumer expense.My rebuttal is simple: Inflation matters, not just consumer inflation.Home price inflation does not show up anywhere because it is not counted anywhere. But ask the guy on the street struggling to buy a house if he views home prices as inflation.The Fed and economists in general are in serious disconnect here about what matters and what inflation is.Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?)I mentioned a Fed study and Fleck dismissed it out of hand immediately without reading. It is very much worth a look.Please consider Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?)Citation: Please cite this paper as: Rudd, Jeremy B. (2021). “Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?),” Finance and Economics Discussion Series 2021-062. Washington: Board of Governors of the Federal Reserve System, https://doi.org/10.17016/FEDS.2021.062.The introduction alone tells you what you need to know.Introduction

Mainstream economics is replete with ideas that “everyone knows” to be true, but that are actually arrant nonsense.

Body

Two of the earliest theoretical arguments for assigning an explicit role for inflation expectations in a Phillips curve relation are found in Phelps (1967) and Friedman (1968).

Specifically, Friedman posited that workers entered the wage bargain with a concern over anticipated real wages (the concern with real wages is of course a reasonable one if money illusion is absent) while firms’ hiring decisions were based on actual real wages (no distinction was made between the consumption and product wage).

It is an irony of history (or perhaps a testimony to the power of pure thought) that, when Phelps and Friedman sought to justify their proposed theoretical specifications, they were faced with the uncomfortable fact that empirical Phillips curves appeared to be remarkably stable.

The direct evidence for an expected inflation channel was never very strong. Most empirical tests concerned themselves with the proposition that there was no permanent Phillips curve tradeoff, in the sense that the coefficients on lagged inflation in an inflation equation summed to one.

Finally, even if one is willing to entertain the idea that in some vague, mushy sense concern over costs and demand by individual firms facing fixed prices leads to a dependence of aggregate inflation on expected inflation, we are still left with the conclusion that short-run expectations should be the ones that are most important.

An important policy implication would be that it is far more useful to ensure that inflation remains off of people’s radar screens than it would be to attempt to “reanchor” expected inflation at some level that policymakers viewed as being more consistent with their stated inflation goal.

One might also be uneasy about policymakers’ relying too heavily on the assumption that inflation’s long-run trend will remain stable going forward so long as measured long-run inflation expectations do. Even if every one of my preceding arguments is judged by the reader to be completely unconvincing, it nevertheless remains the case that we have nothing better than circumstantial evidence for a relationship between long-run expected inflation and inflation’s longrun trend, and no evidence at all about what might be required to keep that trend fixed (beyond that it might involve keeping actual inflation from moving up too much above two percent on a sustained basis).

[Mish note: The last two paragraphs are a direct criticism of Fed policy as practiced by every Fed chair and people dismiss these reports without reading. The next paragraph is a hoot as well.]

Or would you justify the view that expectations “matter” by pointing to the inflation experience of the 1960s and 1970s, even though that period provides no actual evidence that workers or firms tried to boost their wages or raise their prices in anticipation of future price or cost changes?

Why Do People Believe in Nonsense?The answer is that it is hyped everywhere so much that hardly anyone ever bothers to question it.Those who don’t like Fed studies simply because they were written by the Fed, might prefer this view by Brookings. The article is copy protected so consider this snip.The essence of that nonsensical clip is that if people believe the Fed will deliver 2 percent inflation then they will not react when prices go higher.I agree with one thing: “It is the “conventional story, dominant in central banks around the world.“Those who don’t like Fed studies might also prefer this view by the IMF, written May, 15, 2023.

The poor performance of the static Phillips Curve during The Great Inflation period generated interest in other explanations. Contrary to earlier beliefs, there was no permanent tradeoff between inflation and unemployment.

What is striking is that observed inflation fell much more quickly than long-run inflation expectations, as proxied by long-term bond yields. [Mish comment: long-term bond yield are a poor predictor of inflation as well … YET …]

To this day, central banks remain very attentive to ensuring that measures of long-run inflation expectations (market and survey-based) remain near their targets, and for good reasons. [Mish: No good reasons were given]

[And for added humor] The use of survey expectations improves the New Keynesian Phillips Curve’s empirical performance, but also introduces a theoretical inconsistency. The curve’s specific form rests on the assumption of rational expectations, which does not hold with survey data. If you drop the rational expectations component, you also lose the microfoundations of the New Keynesian Phillips Curve. [Mish comment: if you tinker with the theory to explain what went wrong, you break something else in the theory.]

Specifically, in the period following the Great Financial Crisis, central banks were very concerned that a fall in long-run inflation expectations would reduce current inflation and compress policy space. But the recent inflation surge has put at least a temporary stop to such worries. [Mish comment: No doubt about that]

Currently, long-run inflation expectations seem to have remained fairly well anchored. But should expectations de-anchor, bringing down inflation could be much more painful. Therefore, central banks also need to consider the impact of shorter-term expectations on inflation dynamics.

The Phillips Curve is Not Dead Yet – Janet YellenOn January 15, 2019: I wrote Yet Another Fed Study Concludes Phillips Curve is Nonsense

The Phillips Curve, an economic model developed by A. W. Phillips purports that inflation and unemployment have a stable and inverse relationship.

This has been a fundamental guiding economic theory used by the Fed for decades to set interest rates. Various studies have proven the theory is bogus, yet proponents keep believing.

For example, in March of 2017, Janet Yellen commented the “Phillips Curve is Alive“.

Cato noted the Phillips Curve Is Dead (except in Federal Reserve and CBO models).

On August 29, 2017 I noted that a Fed Study Shows Phillips Curve Is Useless. Yet, economists keep trying.Solving the Inflation Puzzle

Yes Virginia, there is inflation. Central banks don’t see it because they are clueless about how to measure it.https://t.co/ek7Y4jB9R6

— Mike “Mish” Shedlock (@MishGEA) August 3, 2017
Ten Things That Increase Consumer Inflation

Please expand the above list with as many items you can think of. For grins, add inflation expectations, then order the list in terms of importance.Two Things That Don’t Increase Consumer Inflation

I am sure to get objections on QE.But look at reported CPI and PCE inflation. There is no reasonable case to be made that QE increased consumer inflation. The Fed was struggling for a decade to get inflation to 2 percent.I hope you caught the key word “consumer”. QE created monster housing and asset bubbles. But as chastised above, the Fed and economists in general do not view obvious housing bubbles as inflation.The Fed is only focused on “consumer inflation” as measured by the CPI and PCE. Inflation expectations are based on New York Fed and University of Michigan surveys.Fed Minutes March 15-16 2022Please consider this snip from the Fed Minutes of the FOMC Meeting March 15-16 2022

A few participants commented that both survey- and market-based measures of short term inflation expectations were at historically high levels. Several other participants noted that longer-term measures of inflation expectations from households, professional forecasters, and market participants still appeared to remain well anchored, which—together with appropriate monetary policy and an eventual easing of supply constraints—would support a return of inflation over time to levels consistent with the Committee’s longer-run goal.

 On March 9th, 2022 the Federal Reserve conducted their final open market purchase effectively ending the Covid QE program started in March 2020.CPI Inflation was running at 5.0 percent, the Fed was still conducting QE, and these clowns had belief that “inflation expectations” would save the day.Fed Minutes: “Longer-term measures of inflation expectations from households, professional forecasters, and market participants still appeared to remain well anchored.”Stupidity is what’s well anchored.Inflation Expectation IronyFrom the Fed study: An important policy implication would be that it is far more useful to ensure that inflation remains off of people’s radar screens than it would be to attempt to “re-anchor” expected inflation at some level that policymakers viewed as being more consistent with their stated inflation goal.But let’s not consider that idea because it is from a useless Fed study.On the nonsensical ideas that “inflation expectations were well anchored” and would thus take care of themselves, the Fed did not start hiking until inflation was already a hot 5.0 percent.The massive irony is that inflation expectations do not matter at all to consumer price inflation. However, the Fed’s ignorant belief in inflation expectations does matter.On belief that expectations matter, the Fed time and time again found reasons to continue QE and not hike rates. The Fed kept QE going, fueling asset bubbles until the bitter end on the basis that inflation expectations were “well anchored”.The Fed study was not only accurate, it was funny, replete with humorous quotes. Here are some of the quotes in the article.Amusing Quotes

Did My Examples Change Anyone’s Mind?Few things are harder to put up with than the annoyance of a good example: Mark Twain, The Tragedy of Pudd’nhead Wilson (1894)I am going to have to read that book to see what else I am missing.However, I suspect I changed very few minds, and certainly none of the minds of the Fed Presidents, even if by some miracle they read this post.It is far, far better and much safer to have a firm anchor in nonsense than to put out on the troubled seas of thought. John Kenneth Galbraith (1958)Podcast With Peter Grandich

A Few Minutes With Peter Grandich and Guest, “The Mish”. https://t.co/Hmt6zAbCjZ@MishGEA

— Peter Grandich (@PeterGrandich) November 28, 2023
On Tuesday, November 28, Peter Grandich interviewed me. The interview was scheduled weeks ago. There was no discussion of topics, just a request.On Tuesday, it went like this.Peter: What do you want to talk about, Mish?Me: Inflation expectations.A week ago, I had no idea that would even be on my mind. I thought I had thoroughly debunked the idea many times. But clearly I hadn’t.We also discussed other aspects of inflation, Fed policy, housing, Bitcoin, and other topics that were on Peter’s mind.Finally, please consider Hoot of the Day: Biden Creates a New Economic Council on Supply ChainsNearly everything Biden does raises my expectation of inflation. If so, it’s Biden’s actions that will increase inflation, not my expectation.For those in doubt please read the Fed study and go over my charts.More By This Author:ISM Manufacturing Contracts For The 13th Consecutive Month, Order Backlogs Plunge The Green Fantasy Ends Because Consumers Don’t Want To Pay For It Real Income Jumps 0.3 Percent Thanks To No Reported Inflation