June 27, 2022

Chart of the Week: Inflation – a psychological phenomenon

by Fathom Consulting.

Milton Friedman said that inflation is always and everywhere a monetary phenomenon. You could say that it is always a psychological one, too. While the balance between demand and supply is important for gauging whether inflation rises or falls, expectations are arguably more important for figuring out the level at which it will settle. In that sense, it is self-fulfilling: if businesses and households expect it to be 5% in the medium term, they will set wages and prices at that level, and that is where it will gravitate. This is the reason that a 0.2 percentage point increase in five-year inflation expectations among US households spooked the FOMC, leading to a 75-basis point hike in June rather than the previously telegraphed 50-basis point increase. So it will come as a relief to policymakers that this initial increase in inflation expectations has been revised away in the final reading. The result? Investors pared back their view on how high interest rates will need to go. In our view, however, given relatively stable inflation expectations and a deteriorating growth and labour market outlook, their view needs paring back still further.

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