How Consumer Expectations Can Affect Inflation

There’s a reason why central banks keep one eye on what the public believes. 

When it comes to the economy, sometimes what people think will happen can be as important as what’s actually happening right now. It’s why policymakers pay close attention to consumer expectations about inflation. 

Case in point: A few weeks ago, the Federal Reserve Bank of New York released its most recent Survey of Consumer Expectations, a nationally representative look at what consumers believe will happen to prices and the overall economy in the coming years.

The median expectation among respondents was that a year from now, inflation would be about 3%, reflecting no change from the previous survey. 

However, economists were somewhat concerned because survey respondents thought that annual inflation would be higher than previously expected three and five years from now. 

Instead of annual inflation hitting 2.4% in three years, the respondents thought it would be 2.7%. At the five-year mark, they thought it would be 2.9% instead of 2.5%. Both are above the 2% inflation target used by the US Federal Reserve, the European Central Bank and other regions’ policymakers as their goal for normal inflation levels.

The NY Fed survey attracted attention because of the idea that consumer expectations can affect consumer behavior. According to the theory, people who expect inflation to keep growing will take actions that make higher inflation more likely.  

And if inflation stays high, central banks could be forced to keep interest rates high, making capital more expensive for consumers and businesses. 

How can expectations about the future change consumer behavior?

In extreme cases, consumer expectations could lead to a wage-price spiral.

• Workers believe that prices will keep growing, so they either push for higher pay or leave for new jobs that will pay more. 
• Employers raise wages, either to keep their current staff or make it easier to recruit new workers. To afford those higher wages, the employers raise prices, too.
• And that leads workers to push for even higher wages, which eventually leads to higher prices, which leads to higher wages, and on and on.  

Central banks want prices to be relatively stable and predictable because it encourages long-term decisions and investments like consumers buying homes or businesses opening new buildings and launching new lines of business.

How anchoring and forward guidance affect consumer inflation expectations

Not everyone expects inflation to be higher a few years from now. 

The Bank of England’s most recent survey found that consumers’ expectations for inflation declined both for a year from now and five years from now. A similar survey from the European Central Bank found the one-year expectation to be up slightly, while the three-year expectation hasn’t changed. 

The Federal Reserve chair, Jerome Powell, also says that inflation is expected to fall. While it’s still above the target range, he argues that most people expect inflation to return to 2%.

“Longer-term inflation expectations appear to remain well anchored, as reflected in a broad range of surveys of households, businesses, and forecasters, as well as measures from financial markets,” Powell said in a news conference on March 20.

“The median projection in the SEP (Summary of Economic Projections) for total PCE (Personal Consumption Expenditures) inflation falls to 2.4 percent this year, 2.2 percent next year, and 2 percent in 2026,” he said. 

When Powell talks about anchoring, he means the degree to which consumers believe that, ultimately, inflation will return to 2% despite any short-term disruptions. 

Interest rates and inflation might be bad today, but if you believe that everything will return to “normal” in a year or so, you’ll probably be less likely to take major action, like raising your prices or pushing hard for a wage increase. 

Forward guidance

Central banks possess the ability to influence consumer expectations. Obviously, that includes raising interest rates to dampen growth and costs.  

But they can also influence public opinion with statements on what actions they expect to take in the near future — aka forward guidance. 

If the Fed says that it plans to postpone rate cuts, for example, that could lead consumers and businesses to delay their own plans for purchases or expansions that, collectively, would lead to higher prices and higher inflation. 

The bottom line about consumer expectations

Public opinion isn’t a perfectly accurate indicator when it comes to inflation. But it can serve as one more early signal of what the economy will look like going forward. It’s also another clue for understanding how policymakers approach the decision to hold or raise interest rates. 

And that, in turn, can influence how your company chooses to use capital and invest in growth. 

Fortunately, even when interest rates soar, most businesses can access alternative sources of capital. For example, dynamic discounting can give companies the ability to get paid early by their customers in exchange for a discount. C2FO’s Early Pay allows suppliers to name the size of that discount. 

Learn more about C2FO and how its platform works here.