Inflation expectations play a crucial role in macroeconomics, influencing both consumer and business pricing behavior while also serving as a key reference for central bank decision-making. As such, stable inflation expectations are essential for economic stability, maintaining purchasing power, and shaping effective policy formulation.
Since Trump announced his bid for the U.S. presidency, debates over whether his potential tariff policies would drive inflation higher have never ceased. Federal Reserve Chair Jerome Powell has repeatedly stated in public appearances that past research indicates if inflation expectations can be effectively "anchored," overall inflation can remain stable even after implementing tariff policies.
However, the latest University of Michigan Consumer Sentiment Report highlights that many consumers are increasingly concerned that inflation will reignite next year. The 1-year inflation expectation jumped from 3.3% to 4.3%, marking only the fifth time in the past 14 years that it has surged by a full percentage point in a single instance. Meanwhile, the 5-year inflation expectation also rose to 3.3%, significantly higher than the 2.2%–2.6% range observed over the past two years.
So, what exactly is the role of inflation expectations in the economic cycle? Why do central banks worldwide emphasize the importance of "anchoring" this metric? In the following discussion, we will explore the concept, historical development, and significance of inflation expectations, shedding light on how they influence business, labor, and consumer behavior, ultimately shaping macroeconomic stability.
Concept of Inflation Expectations
Inflation expectations refer to economic agents' projections of future price levels, influencing a broad range of factors, including business pricing strategies, wage negotiations, consumption and investment decisions, as well as government and central bank monetary policy formulation. Powell has previously stated in a 2019 congressional hearing that "inflation expectations" are the most important driver of actual inflation.
The primary mechanism through which inflation expectations drive actual inflation is the self-fulfilling mechanism. If the market broadly anticipates future inflation to rise, businesses may preemptively increase prices, and workers may demand higher wages, ultimately fueling actual inflation. Conversely, if inflation expectations decline, inflationary pressures may ease, potentially leading to deflation risks. This is why major central banks around the world have made managing inflation expectations a core objective of monetary policy.
Historical of Inflation Expectations
The foundation of inflation expectations dates back to Irving Fisher's "Fisher Effect" (1896). Fisher argued that if prices are expected to rise in the future, the real purchasing power of borrowed money would diminish, leading lenders to incorporate compensation for expected inflation into nominal interest rates. Thus, nominal interest rates should theoretically be the sum of real interest rates and inflation expectations.
But where do inflation expectations originate? Fisher suggested that while individuals cannot perfectly predict inflation, economic activity, information dissemination, and an increasingly sophisticated understanding of markets would gradually narrow the gap between expected and actual inflation.
From this premise, the adaptive expectations theory emerged. This theory posits that individuals adjust their inflation expectations based on a weighted average of past inflation experiences, assuming that people rely on past inflation trends to gradually modify their outlook.
Trade-off Between Unemployment and Inflation Expectations: The Phillips Curve
In the 1960s, economists extensively studied the relationship between unemployment and inflation, theorizing that expansionary policies to lower unemployment typically led to wage growth and higher inflation—suggesting a trade-off between the two variables, known as the Phillips Curve.
(Source: Federal Reserve Bank of St.Louis)
However, Milton Friedman challenged this perspective, arguing that workers primarily care about real purchasing power. To maintain stable purchasing power, they would adjust their wage demands based on expected inflation. This implied that the relationship between unemployment and inflation should incorporate inflation expectations.
Friedman warned that policymakers attempting to sustain unemployment below its natural rate would have to continuously raise inflation at an "unexpected" pace to outstrip adjusted expectations, ultimately pushing inflation to unsustainable levels.
Thus, Friedman cautioned that the inflation-unemployment trade-off was unsustainable in the long run. While unexpected inflation spikes might temporarily reduce unemployment, prolonged high inflation would render this strategy ineffective.
The Breakdown of Inflation Control: Phillips Curve Fails
By the 1970s, the U.S. government pursued conflicting fiscal policies—expanding spending for the "Great Society" programs and the Vietnam War while simultaneously implementing tax cuts.
These measures led to escalating fiscal deficits and deteriorating economic conditions. Compounding the issue, the collapse of the Bretton Woods system in 1973 triggered a sharp depreciation of the U.S. dollar, while soaring food prices fueled inflation.
Despite these warning signs, the Federal Reserve relied on the "stop-go" monetary policy approach, where periods of expansionary policy (to lower unemployment) alternated with periods of tightening (to curb inflation).
However, as Milton Friedman had forewarned, the trade-off between inflation and unemployment was unsustainable in the long run. In an environment of persistently high inflation, price increases became fully anticipated, diminishing their ability to "surprise" the public and influence real economic variables.
Although the Fed was aware of surging inflation, it remained overly focused on full employment, leading to consistently loose monetary policy. As a result, inflation continued to rise in both expansionary and contractionary policy cycles, yet unemployment failed to decline meaningfully during monetary easing phases. This ultimately undermined the effectiveness of the Phillips Curve, setting the stage for the stagflation crisis that followed.
The 1979 Oil Crisis and the Rise of Rational Expectations
In early 1979, the Iranian Revolution triggered the second oil crisis, exacerbating inflation expectations as energy shortages fueled economic uncertainty.
Although the Fed attempted to curb inflation by raising interest rates, persistent high inflation had already eroded public confidence in its ability to control price stability. As a result, inflation soared unchecked, while rising interest rates suppressed investment and employment, plunging the U.S. into stagflation.
In response to this failure, economists Robert Lucas and Thomas Sargent revisited the work of John Muth, proposing the "Rational Expectations" Theory.
Rational Expectations suggests that individuals incorporate all available information into their forecasts, rather than solely relying on past trends. Consequently, if markets anticipate inflationary policies, consumers and businesses will preemptively act—accelerating inflation through a self-fulfilling prophecy.
This framework also implies that people can rationally predict policy shifts. If policymakers attempt to lower unemployment by covertly allowing higher inflation, individuals will recognize this tactic in advance, neutralizing its effectiveness.
Breaking Stagflation: Paul Volcker’s Determination
By the early 1980s, newly appointed Fed Chair Paul Volcker identified high inflation as the primary threat to future economic growth. He criticized the Fed’s prolonged negligence, arguing that it had severely undermined public trust.
To combat inflation, Volcker raised the federal funds rate to nearly 20%, cut monetary supply, and consistently reinforced the Fed’s commitment to inflation control. Though this aggressive tightening plunged the U.S. into recession, pushing unemployment from 7% to 10%, it successfully broke the cycle of inflation expectations. Inflation gradually fell from 14% to around 3% over subsequent years.
After the crisis, central banks around the world came to a crucial realization—tolerating high inflation in exchange for temporarily lower unemployment would ultimately backfire as long-term risks accumulated under rational expectations. Instead of debating whether inflation should be allowed to rise in order to reduce unemployment, policymakers began focusing on maintaining public confidence in price stability. This fundamental shift in thinking laid the groundwork for the later adoption of Inflation Targeting.
The core principle of Inflation Targeting lies in the explicit establishment of a public inflation target (such as 2%), which serves to anchor long-term inflation expectations and reinforce price stability. At the same time, this framework emphasizes proactive and transparent policy communication to ensure that inflation expectations remain well-anchored over the long run.
In the 1990s, the Reserve Bank of New Zealand became the first central bank to adopt Inflation Targeting, achieving notable success. Following its lead, other major central banks—including those in Canada, the United Kingdom, Sweden, and the United States—also gradually incorporated Inflation Targeting into their monetary policy strategies.
Application of Inflation Targeting in Recent Economic Crises
The adoption of Inflation Targeting has played a crucial role in navigating economic crises over the past two decades. During the 2008 Global Financial Crisis, many economies faced severe risks of recession, and market expectations shifted toward a potential decline in future price levels. This led to weaker consumption and investment activity, increasing the risk of a self-fulfilling deflationary spiral.
To prevent prolonged deflation, the Federal Reserve (Fed), the Bank of Japan (BOJ), and the European Central Bank (ECB) implemented multiple rounds of large-scale Quantitative Easing (QE) and aggressively lowered interest rates to stimulate demand. At the same time, they reinforced the importance of Inflation Targeting, which successfully helped prevent deflation from spiraling out of control.
During the COVID-19 pandemic in 2020, governments and central banks worldwide implemented unprecedented fiscal and monetary stimulus to support economic activity, causing a rapid rebound in demand. However, global inflation surged due to supply chain bottlenecks, rising energy prices, and labor shortages, fueling concerns over a potential return of stagflation.
In response, the Federal Reserve and other major central banks accelerated interest rate hikes in 2022 and launched Quantitative Tightening (QT) to prevent inflation expectations from becoming unanchored. Over the past two years, inflation has steadily declined from a peak of 8-9% to around 2-3%. These events have once again underscored the critical importance of managing inflation expectations in central banks' efforts to control inflation risks.
Inflation Expectation Indicators
Currently, various inflation expectation indicators are available to both the general public and policymakers for reference:
- Market-Based Inflation Expectations: 10-Year Breakeven Inflation Rate in the U.S
- Survey-Based Inflation Expectations: 1-year and 5-year inflation expectations from the University of Michigan Consumer Sentiment Index
- Professional Forecasts: These consist of projections from institutions such as the Federal Reserve’s "Dot Plot" and the European Central Bank’s (ECB) Survey of Professional Forecasters
The historical evolution of inflation expectations highlights their critical role in economic stability and the effectiveness of monetary policy. From the high inflation crisis of the 1970s, to the adoption of Inflation Targeting in the 1990s, to the 2008 Global Financial Crisis, and the resurgence of inflation following COVID-19, inflation expectations have remained a key variable in shaping macroeconomic dynamics.