Federal Reserve Governor Christopher Waller has made it clear that the central bank is playing a different game on inflation than it did in the 1970s.
The recent March Consumer Price Index (CPI) report showed a sharp 0.90% monthly jump, the largest since 2022, pushing the annual rate to 3.3%. With gasoline prices accounting for most of this increase, it's the kind of headline number that can cause alarm. However, Waller’s comments suggest the Fed's reaction function has evolved, focusing less on the immediate shock and more on its potential to infect long-term psychology.
This new approach hinges on the concept of inflation expectations. The core lesson from the 1970s was that once people and businesses expect high inflation to continue, it becomes a self-fulfilling prophecy. They demand higher wages and set higher prices, creating a persistent wage-price spiral. The Fed’s main job today is to prevent that from happening by keeping long-term expectations firmly 'anchored' to its 2% target.
So, how does the Fed gauge this? First, it distinguishes between short-term fear and long-term belief. Recent data shows a clear split. The University of Michigan's survey revealed a plunge in consumer sentiment, with short-term (1-year) inflation expectations surging to 4.8%. This reflects the immediate pain at the pump. In contrast, market-based measures like the 5-year breakeven inflation rate and the New York Fed's survey show that long-term expectations remain stable, hovering around 2.2-2.6%. This is the crucial difference from the 1970s, when all measures of expectations spiraled upwards together.
Because these long-term expectations are still anchored, the Fed feels it can 'look through' the temporary supply shock from energy prices. The goal isn't to control the price of gasoline but to ensure that today's high gas prices don't cause people to believe inflation will be 5% forever. As long as that anchor holds, the Fed can stick to its plan, which currently includes a potential interest rate cut later in the year, without overreacting and potentially harming the economy.
- Inflation Expectations: The rate at which people—consumers, businesses, and investors—expect prices to rise in the future. It's a key driver of actual inflation.
- Anchoring: A situation where long-term inflation expectations remain stable and close to the central bank's target, even when there are short-term price shocks.
- Breakeven Inflation Rate: A market-based measure of expected inflation derived from the difference in yield between a nominal government bond and an inflation-protected bond of the same maturity.