29 FEBRUARY 2024
Inflation expectations play a vital role in setting Central Bank policy, although deciding on what metric to use can be a challenge. Some policymakers refer to survey-based measures, which simply asks consumers and businesses what they think the inflation rate will be over the coming years.
Another approach is to use market prices calculated by backing out the implied future inflation rate from inflation-linked bonds. This captures what market participants anticipate inflation will likely be going forward with the 2-year swaps based inflation expectation (shown below) one of the preferred indicators.
Whatever the measure, policymakers like to understand what people are thinking about inflation because expectations tend to become self-fulfilling. For instance, if future inflation is expected to be high, workers demand higher wages, businesses tend to raise prices and consumers will adjust their spending patterns accordingly.
This is more than a theory. As the chart below shows, US inflation expectations surged in the immediate aftermath of the pandemic with the 2yr rate peaking close to 5% around the start of the Russia/Ukraine war. This elicited a strong response from the Fed, which unleashed one of the most aggressive rate hike cycles on record.
However, inflation expectations have fallen sharply over the past 2 years with the 2yr rate back to around 2%, close to its pre-Covid norm. The Fed will find this encouraging and providing inflation expectations remain relatively contained, there is no reason to doubt the start of US rate cuts later this year.
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