If President Donald Trump’s implementation of tariffs results in increased US consumer prices, as widely anticipated, it poses a challenge for inflation control efforts by the Federal Reserve. Moreover, it could lead to a more concerning situation.
Economists emphasize that the expectations of businesses and workers regarding future prices can significantly influence actual price developments. Consequently, Federal Reserve officials closely monitor forecasts of future inflation, which currently indicate potential issues. The primary long-term expectations indicator, having already reached a 30-year high since Trump’s election, surged further following his extensive global tariffs.
Such perceptions could transform a temporary price increase from Trump’s trade war into a sustained inflationary trend. This risk is heightened as it emerges while American households remain affected by the post-pandemic price spike and might doubt the Federal Reserve’s capacity to prevent a recurrence.
Consumer and business inflation estimates reflect public confidence in central banks and their ability to control prices. Deterioration in this trust, especially over the long term, suggests that monetary policy could become inefficient. Concretely, more elevated interest rates are required to restore trust.
A significant rise in long-term expectations might indicate declining confidence in the Fed’s capacity to return inflation to 2%. Jeffrey Fuhrer, a former director of research at the Boston Fed, currently at the Brookings Institution, expressed concern about such a scenario. Although most surveys do not indicate this level of trust erosion, a trade war still complicates the Fed’s role. If tariffs lead to consumer price increases exceeding 3% in the coming year, they may adjust to this as a new norm, affecting wage demands and pricing strategies. Fuhrer cautioned that this could result in a “problem” that is currently unnecessary.
As of March, key US inflation measures were around 2.5%, significantly reduced from their 2022 highs but stubbornly above target. Most economists anticipate a rise as tariffs increase import costs.
The University of Michigan’s latest survey shows consumers expecting a 6.7% price rise in the next year and an annual 4.4% increase over a 5-10 year horizon, both historic highs. Despite some skepticism about the methodology, the Conference Board’s year-ahead index has also risen since December.
However, other data sources present a less alarming view. Market indicators like Treasury bond-based five- and ten-year breakevens approximate the Fed’s 2% target. The New York Fed’s February Survey of Consumer Expectations reported stable three- and five-year inflation projections unaffected by the trade war, at around 3%. The results of the March survey are awaited.
This prompted Fed Chair Jerome Powell to dismiss the Michigan results as an “outlier.” Nonetheless, Powell and his colleagues maintain vigilant monitoring of inflation expectations as they navigate the trade war.
Susan Collins, President of the Boston Fed, emphasized the importance of the Federal Reserve’s credibility, reflected in stable longer-term inflation expectations. She noted that the tariff impact might be “more broad-based than many people realize.”
Fed officials had already adjusted growth forecasts downwards and inflation upwards before Trump’s tariff announcements. They have since warned that consumer prices might rise around 4% this year. These developments have motivated a decision to avoid rate cuts and maintain borrowing costs despite economic slowdown concerns.
Historically stable US inflation since the early 1990s has kept expectations in check until recent years. However, post-pandemic and Ukraine war-induced price shocks have altered this, elevating these forward-looking measures.
Joseph Brusuelas, chief economist at RSM US LLP, highlighted ongoing consumer struggle, as reflected in their inflation survey responses. Despite a lack of automatic correlation between expected and actual price rises, especially in the US, encompassing research supports the relevance of expectations.
Michael Weber, a University of Chicago professor, studied the effects of Germany’s post-World War I hyperinflation and found enduringly higher price expectations in previously high-inflation areas, influencing local politics.
For central bankers, past experiences inform current approaches. Fed officials most vocal about inflation expectation surveys often have international backgrounds or connections to high-inflation regions like Latin America. According to Weber, inflation concerns are influenced by one’s origins.
Ricardo Reis of the London School of Economics advises central bankers to consider a broad range of measures, understand that above-target expectations create lasting impacts, and take prompt action when necessary. He notes that the pandemic price surge serves as a reminder of the importance of maintaining credible inflation expectations.
Reis argues against ignoring these challenges, labeling them as transitory or non-existent, as ineffective responses.
This information was initially published on Fortune.com.
