The Fed has focused its attention on inflation expectations, which for both consumers and businesses, have come down to about 3%. Businesses tend to have more flexibility with pricing power if expectations are broadly higher. Said differently, if I think inflation is going to be higher, then I won’t be surprised when grocery stores start posting higher prices. 

The tendency is to believe things will continue to move in the direction they’re currently moving. High prices will continue to go higher. When gas prices peaked last summer, there were calls that it would reach $6 per gallon. Gas prices peaked at $5.10 nationally in June 2022. 

Hindsight allows me to poke at past predictions but if gas prices did reach $6 per gallon, I don’t think anyone would be shocked. Angry, yes. But not at all surprised. Expectations are powerful and prepares us for the worst possible scenarios. 

What happened was global demand shrank through a combination of China’s lockdowns, slowing shipping activity, and drivers simply consuming less gas. 

We can apply these expectations to everything we spend money on. When we hear restaurants are charging more, no one is surprised to see the check is higher than what we’re accustomed to. If we’re always going to expect much higher prices in the near future, inflation expectations are suddenly anchored. This is the very thing the Fed is trying to prevent. 

By raising rates, the Fed is simply making accessing money more expensive or more difficult. They’re attempting to solve the problem by making higher prices inaccessible for a portion of the population. Less demand would in turn reduce inflation. 

In theory, this might make sense. But when consumers who aren’t in the market for a car still have an expectation that car prices are higher. When they eventually come around to buying a car, they are already prepared to pay more. An even worse scenario would be if someone looking to buy a car down the road sped up the timeline of their purchase because they believed car prices would be higher in the future. This pulls forward future demand which creates the cycle of inflation expectations and actual inflation. 

Taking away the capability of large purchases can quell expectations, but it has to be done on a large enough scale to impact the psychology of millions of people. It’s an imprecise tool that will create a wide range of outcomes. We may pull out of this unscathed but we could also experience a deeper-than-expected recession. Only time will tell. 

In theory, people need to see prices stabilize before lowering their expectations for future inflation. But if we lower our expectations first, suppliers will need to reduce prices to meet lowered demand. If I’m expecting to pay no more than $500 for a washer, then I won’t buy one (if I can help it). If there’s  enough of me then prices would come down to meet my expectations on price. 

In the real world, there’s always someone willing to pay a higher price. That’s what makes expectations hard to shake. I’ll eventually need to replace my washer and pay the higher price. We’re all impacted by others’ spending habits, and in this market, sellers can get away with higher prices because consumers haven’t been willing to step back and reduce spending yet. 

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