What to Expect When Consumers Don’t Expect Inflation to Last

Americans are bummed out about inflation. And yet they don’t seem to see it as a lasting problem.

The University of Michigan on Friday said that, in a preliminary reading, its measure of consumer sentiment among U.S. households fell to 61.7 this month from 67.2 in January. That was the lowest level since 2011. It is a reading that is, in some regards, hard to square with recent news, such as the sharp decline in Covid-19 cases over the past month and the booming job market.

But then there is inflation, which hit a 40-year high last month, and which is cutting into people’s buying power while also raising the specter of higher interest rates. Michigan economist Richard Curtin, who oversees the consumer survey, noted that a third of respondents cited the impact of inflation on their finances, and nearly half of all respondents expected declines in their inflation-adjusted income over the next year.

The sentiment report also showed that the median consumer expects prices to rise by 5% over the next year, up from January’s forecast of 4.9% inflation. That is the highest year-ahead inflation expectations have gotten since July 2008, when the price of gasoline (which can have an outsize influence on inflation perceptions) reached $4.11 a gallon nationally.

But Friday’s report also showed expectations for inflation over the long haul remain relatively muted, with consumers forecasting it will average 3.1% annually over the next five to 10 years. That is as high as consumers’ long-term inflation expectations have gotten since early 2009, but not leaps and bounds above their forecast of 2.3% in February 2020, just before the Covid crisis struck. And considering consumers’ tendency to expect more inflation than they get, 3.1% doesn’t seem all that high.

Investors don’t appear to think inflation will remain all that high, either. The 10-year break-even rate, or the difference between the yield on the 10-year Treasury note and the 10-year Treasury inflation-protected security—which in theory should reflect bond-market participants’ expectation for annual inflation over the next decade—has lately been around 2.5 percentage points. And the TIPS reading is based on the Labor Department’s inflation index. The Commerce Department index the Federal Reserve bases its 2% inflation target on runs cooler.

For the Fed, the fact that long-term inflation expectations haven’t ratcheted significantly higher should be cheering. That is because most economists believe inflation expectations play an important role in where future inflation goes. In short, when inflation expectations are high, people will agitate harder for higher wages than when expectations are low, which helps explain why inflation has been higher in some periods of low unemployment than in others.

Still, the Fed is worried that the longer inflation stays high, the more it will begin to work its way into long-term expectations. If prices don’t start cooling soon, the central bank could start acting very alarmed.

The Federal Reserve has signaled it plans to raise interest rates in 2022 in response to stubbornly high inflation. WSJ’s J.J. McCorvey explains what higher rates could mean for your finances. Photo illustration: Todd Johnson