HomeHow Inflation Expectations Shift

How Inflation Expectations Shift

30 September 2020 By Mircea Vasiu

For now, everyone’s focus is on what happens with the U.S. presidential election. Yesterday’s first debate between the two candidates offered just a glimpse into what we will witness in the weeks before  election day. 

However, the bigger game-changer event from a macro perspective is the change in the Federal Reserve of the United States (Fed) mandate. Until now, the Fed’s mandate centered around targeting 2% inflation and creating jobs. Ever since the last Jackson Hole symposium, the Fed announced a change in the inflation part of the mandate, from inflation targeting to average inflation targeting.

We can give credit to the Fed for its perfect timing. The Jackson Hole symposium took place in August, a summer month when no one really looks into what financial markets are doing. Moreover, such an important announcement, released a couple of months ahead of the presidential election, also let it fly under the radar.

However, make no mistake that the Fed’s decision will remain in history as one of the boldest and most relevant monetary policy shifts in modern times. To avoid what happened in Japan for decades, the Fed laid the ground for shifting inflation expectations.

What Is Inflation and Why Do Inflation Expectations Matter?

Inflation refers to changes in the prices of goods and services over a predetermined period. Inflation can be positive (rising prices from a period to another), negative (falling prices from one period to another). If inflation rises aggressively, say, from 2% to 10% in the course of a couple of months, the economy experiences hyperinflation. On the other hand, if inflation drops from 2% to 1%, the phenomenon is known as disinflation. Finally, when inflation drops below zero, the economy enters deflation.

The aim of a central bank is to avoid deflation by all means. To do so, cutting rates help, but once the rates hit zero, the Fed said it wouldn’t go negative. Doing quantitative easing also works, but this cannot be an ongoing process. Hence, the easiest way to avoid deflation and bring inflation to the 2% rate needed for sustainable economic growth is to create a shift higher in inflation expectations.

If the population believes that prices will rise in the period ahead, it will act accordingly – spend money faster on goods and services and won’t postpone the purchasing decision anymore.

This is what the Fed tried to do (and succeeded so far) with the shift to average inflation targeting. By announcing that it will let inflation overshoot the 2%, the Fed lays down the conditions for inflation expectations to rise.

According to a study run by Blackrock, the market-implied inflation expectations shifted to almost 3%  for 2025-2030 already.

This only from the Fed announcing a change to average inflation targeting – nothing more.  If today’s actions make one believe in a change in future prices, current inflation will tend to converge faster with inflation expectations.

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