Inflation often described as a rise in the general price level of goods and services remains one of the most closely watched economic indicators worldwide. While factors such as supply and demand, monetary policy, and production costs are frequently cited as direct drivers of inflation, there’s a more subtle yet powerful force at work: expectations. In fact, inflation expectations what consumers, businesses, and investors anticipate future inflation will be can be just as influential as tangible economic data. So, what role do expectations play in inflation? The answer is central, dynamic, and increasingly critical in modern macroeconomic policy.
The Psychology Behind Inflation: More Than Just Numbers
At its core, inflation is not just about the cost of groceries or gas it’s also about perception and anticipation. When people believe prices will rise in the future, their behavior changes in ways that can actually bring about the inflation they feared. This self-fulfilling prophecy is the cornerstone of the relationship between expectations and inflation.
For example, if workers expect prices to increase, they may demand higher wages to maintain their purchasing power. Employers, facing higher labor costs, may pass these costs on to consumers through higher prices. In turn, consumers, expecting further price increases, may accelerate spending, creating additional demand pressure. This chain reaction illustrates how expectations can ignite or sustain inflationary trends, even in the absence of immediate supply shocks or excessive money printing.
Anchor or Unravel? The Importance of Well-Managed Expectations
Central banks, particularly institutions like the Federal Reserve and the European Central Bank, recognize the pivotal role of inflation expectations. A key goal of modern monetary policy is to "anchor" expectations at a stable, predictable level usually around 2% in most developed economies.
When expectations are well-anchored, short-term inflation spikes (say, due to oil price shocks or pandemic-related supply chain issues) are less likely to trigger long-term inflation. Markets and individuals trust that the central bank will take corrective measures, and thus, they don’t make lasting behavioral shifts such as demanding permanent wage increases or adjusting long-term contracts based on temporary fluctuations.
However, if these expectations become "unanchored," the consequences can be severe. In the 1970s, for instance, inflation expectations in the U.S. spiraled out of control. After prolonged periods of rising prices, households and firms began to expect inflation as a permanent condition. This led to a wage-price spiral workers demanded higher wages, businesses raised prices, and inflation continued to climb. It wasn’t until the Federal Reserve, under Paul Volcker, aggressively raised interest rates in the early 1980s that inflation and, crucially, inflation expectations were brought back under control.
How Are Expectations Measured?
Economists and policymakers use a variety of tools to gauge inflation expectations:
1. Surveys – These include the University of Michigan Surveys of Consumers, which ask households about their expected inflation over the next year and the next five to ten years, and the Federal Reserve Bank of New York’s Survey of Consumer Expectations. These surveys provide direct insight into public sentiment.
2. Market-Based Indicators – Financial instruments like inflation-linked bonds (e.g., TIPS—Treasury Inflation-Protected Securities in the U.S.) offer a market-driven estimate of expected inflation. The difference in yield between a regular Treasury bond and a TIPS bond of the same maturity the "breakeven inflation rate" reflects what investors expect inflation to be over that period.
3. Professional Forecasters – Groups like the Federal Reserve’s Survey of Professional Forecasters (SPF) compile inflation projections from economists and analysts, providing a consensus view.
Each method has strengths and limitations. Surveys can capture broad sentiment but may be influenced by recent experiences or media coverage. Market-based measures are timely but can be distorted by risk premiums or changes in investor demand unrelated to inflation.
Central Banks and Forward Guidance
Understanding the importance of expectations, central banks have increasingly turned to "forward guidance" as a policy tool. This involves communicating future policy intentions clearly and consistently to shape expectations.
For instance, during and after the 2008 financial crisis, the Federal Reserve signaled that it would keep interest rates near zero for an extended period. This wasn’t just a policy statement it was a strategic effort to lower long-term interest rates by assuring markets that inflation would remain subdued and monetary policy accommodative. Similarly, the European Central Bank and the Bank of Japan have used forward guidance to combat deflationary pressures by convincing markets that policy rates would stay low until inflation targets were sustainably met.
Forward guidance only works, however, if the central bank maintains credibility. A central bank that repeatedly misses its inflation target or sends mixed messages risks losing the trust of the public and markets. Once credibility erodes, anchoring expectations becomes significantly more difficult.
The Risk of De-Anchoring in Turbulent Times
Recent years have provided stark reminders of how easily inflation expectations can become destabilized. The global pandemic, followed by supply chain disruptions, energy price shocks due to geopolitical conflict, and significant fiscal and monetary stimulus, created a perfect storm. In 2021 and 2022, inflation soared in many countries leading to fears that expectations might de-anchor.
In the U.S., for example, year-ahead inflation expectations from the University of Michigan survey spiked to multi-decade highs, exceeding 5% at one point. While longer-term expectations remained more stable, the increase signaled concern. In response, the Federal Reserve began a rapid series of interest rate hikes under Chair Jerome Powell, explicitly aiming not only to reduce actual inflation but also to "secure longer-term inflation expectations."
So far, the effort has shown some success. As inflation has eased and expectations have cooled, central banks have indicated that they believe expectations remain broadly anchored. But the episode underscored how fragile this anchoring can be in the face of unexpected shocks and shifting narratives.
Expectations in Developing Economies
The role of expectations can be even more pronounced in emerging markets and developing economies. In countries with histories of hyperinflation such as Zimbabwe, Argentina, or Venezuela expectations are often highly sensitive. Once people lose faith in the stability of their currency, they may rush to spend money quickly or convert it into foreign currencies or assets, accelerating inflation.
In such contexts, rebuilding credible monetary institutions and consistently meeting inflation targets are essential not just for short-term stability but for restoring public trust over the long term.
Conclusion: Inflation Is as Much About Belief as Economics
To answer the question what role do expectations play in inflation? we must recognize that expectations are more than a secondary factor; they are a central mechanism through which inflation takes hold or subsides. Whether individuals, firms, or investors believe inflation will rise or fall shapes their decisions on spending, saving, investing, and wage bargaining. These actions, in turn, influence actual inflation outcomes.
For policymakers, the challenge is not only to manage economic variables like money supply and interest rates but also to manage perceptions. In today’s information-rich and highly interconnected world, clear communication, policy consistency, and institutional credibility are as vital as any traditional lever of economic control.
Ultimately, inflation is not just a number measured by statisticians it’s a story told through expectations. And like any powerful narrative, once it takes root, it can be difficult to change. That is why, in the battle against inflation, winning the war of expectations is often the first and most crucial step.