Inflation Expectations: Are They Imbedded?

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Do inflation expectations shape inflation in subsequent periods? The Federal Reserve focuses on keeping expectations “anchored” as a key to managing inflation. The Fed wants expectations anchored around their 2% target, which by the way, is not “price stability.”

Chart 1 shows the relationship between small business owner plans to raise prices by 5% or more and the actual percent reporting higher prices in that range three months later. Although the results are not based on repeat interviews with the same respondents from quarter to quarter (each survey is a random sample of NFIB’s member firms), there is a very high correlation between “plans” of small business owners and the incidence of “actual” price hikes reported among owners. Regressing the percent reporting actual price increases on plans in the prior quarter demonstrated a very strong relationship between plans and actual actions in the next quarter.[1] Each percentage point increase in price plans of 5% or more this period will produce a 1.5 percentage point increase in the percent actually raising prices by that much in the following quarter. So, if owners see a need to raise prices, they will accomplish it in the next quarter, along with many owners who didn’t plan to raise prices but found it necessary.

Chart 1: Planned and Actual Price Increases

NFIB Small Business Economics Trends Survey (SBET)

Fifty-five percent of those who raised their selling prices plan to raise them again in the next period, 22% don’t know what action they might take, and 21% plan no change. Although this does not reveal the “inflation expectations” that the Fed wants to anchor at 2%, it does indicate that most of those who recently raised prices see the need (due to higher labor and operating costs) to raise prices again. Twenty-three percent of those planning price hikes plan increases of 5% or more, way above the 2% target of Fed policy.

The Federal Reserve is “behind the curve,” providing stimulus to the economy even as inflation numbers worsened last year. Reluctant to raise rates to head off inflation, the Fed will now have to accelerate the rate hikes and stop buying government securities. This will be unhappy news for financial markets and housing prices. It will also slow economic activity. If, or more likely when, this shows up in the employment statistics the Fed will once again be trapped in between its two conflicting objectives: full employment and stable prices. But with CPI at levels not seen since 1981, easing inflation is now the focus.

[1] A linear regression describes the relationship as: % Raising Prices = -2.8 + 1.5 * % Plan to Raise in Prior Quarter, R2 = 77%.