Softening Inflation Expectations Are the Beginning Not the End of the Fed’s Hawkish Posturing

The surprisingly bad CPI report caused shockwaves throughout the stock market. Part of the shock likely occurred thanks to the relatively benign news the day before from the New York Federal Reserve’s August 2022 Survey of Consumer Expectations. Expectations for 1-year-ahead and 3-year-ahead inflation declined significantly in August.

The Fed’s aggressive anti-inflationary posturing is apparently finally having a positive impact on inflation expectations. Source: NY Federal Reserve.

I would caution anyone who wants to declare victory from the return of 3-year-ahead expectations to pre-pandemic levels. Inflation expectations were so well-contained for so many years, it is hard to project the dynamics of going from high to normalized expectations. For example, how long does the Fed need to continue its aggressive posture to maintain this momentum? Moreover, if the 1-year ahead expectation remains predictive, the Fed will have to stay on course tightening policy into 2023 as the Fed Fund Futures currently expect per the CME FedWatch Tool.

The market keeps pushing expectations for peak rates higher and higher in 2023. Suddenly, the market thinks the Fed is on track to reach a 5.0% to 5.25% range but then quickly back down by year-end.

The apparent predictive nature of the 1-year ahead expectation is particularly notable. Both the 1- and 3-year-ahead measures increased steadily a few months into the pandemic. A large gap opened starting in June, 2021 at the same time that the Federal Reserve was convinced that inflation was transitory. The comfortable math of “base effects” allowed the Fed and many others to essentially ignore the soaring inflation expectations. Clearly, the average consumer agreed with me and did not believe the story. Expectations just kept climbing for an entire year. It is only in the last 2 months – in the wake of a Fed that is suddenly consumed with anti-inflation religion – that inflation expectations took a notable downward turn. So while the big drop in August is encouraging, the Fed will likely need to maintain the psychological pressure for some time to keep a lid on expectations.

In turn, this necessary pressure could keep a lid on the stock market for a while. The S&P 500 (SPY) closed the week perfectly testing the line that defines a bear market (a 20% decline from the all-time high). We might have to get accustomed to the index pivoting around or near this important, psychological line.

The press release accompanying the NY Fed’s report included several additional key points indicating the worst of inflationary pressures could be in the rearview mirror if the Fed maintains the pressure.

• Median five-year-ahead inflation expectations declined to 2.0% from 2.3%.
• Median home price expectations declined by 1.4 percentage points to 2.1%. This drop represents a dramatic decline from April’s 6.0% and is the lowest reading since July, 2020.

On the other hand, despite inflationary pressures decreasing and respondents reporting declining access to credit, the NY Fed reported “median household spending growth expectations increased by 1.0 percentage point to 7.8%. The increase was driven by those with a high-school degree or less.” At the same time, respondents reported higher odds of missing a minimum debt payment, households felt better about their current and prospective financial condition. Net-net, these numbers tell me that the Fed’s posturing and policy have managed to bring some relief to pricing pressures without crushing economic expectations. These cross-currents will likely resolve in yet unexpected ways.

Be careful out there!

---