Chart of the Week

EVEN EXPECTATIONS

As we’ve noted before, monetary policymakers tend to be fixated on inflation expectations, much more than actual CPI or PPI prints.

This is because they inform what market and economic participants are thinking about the outlook for future prices, which can quickly become self-fulfilling.

For example, when higher inflation is anticipated workers will strive for higher wage growth and businesses will look to increase prices on their goods and services. A general rise in costs across the economy can thus soon unfold, but the converse is true when prices are expected to decline.

The chart below shows market-derived figures for US 2yr, 5yr and 10yr US expectations.

The spike in all three measures between late 2020 and early 2022 helps to explain why the Federal Reserve was panicked into the major rate-hike cycle that ultimately led to a painful drawdown in risk assets.

Fast forward to today and the picture is more nuanced.

The recent upturn in 2yr inflation expectations (dark blue) is consistent with the nascent fears that the Trump tariffs could fuel another round of inflation.

However, unlike the 2021/22 inflation scare, longer-dated inflation expectations are not trending higher. Note how the 5yr expectations (red line) and 10yr expectations (light blue line) are moving sideways.

This is consistent with the idea that tariffs are typically inflationary in the short-term but can be long-term deflationary, as aggregate demand wanes in the face of higher costs.

It is also significant that Central Bankers tend to put most store in the longer-dated expectations.

Simply put, the Federal Reserve should remain relatively relaxed about the inflation backdrop unless, or until, those red and light blue lines start to trend higher.