Inflation and Expectations

Ken Houghton follows up on his previous post.

One of the few honest statements that came out of the Reagan Administration was in late 1982, when the Volcker policies were working but the market was still spooked. “People expect that inflation will be higher than it will be.”

The above compares the University of Michigan’s Consumer Sentiment (prediction of the inflation rate one year forward) with the actual inflation that occurs over that period.

Several things are apparent.

  1. The official inflation target was not really managed well from 2004-2006. (Alternate explanations welcome; I can think of a few.)
  2. Consumers assumed the Fed targets were in effect during that period.
  3. Consumers have consistently overestimated inflation from 2007 onward—and there is no sign of that changing.
  4. There has been deflation since the beginning of 2009.
  5. People still believe the Fed target can be hit.

Combining those last two leads to another clear conclusion that I hope has an alternate explanation: Consumers continue to try to believe the Fed target, even in the face of policy failure.

This may explain the “bizarre complacency“; people believe the economy is in a much different place than it is.

But for how long can they ignore the evidence?

To Be Continued…

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