How well do consumers anticipate inflation?

Source: University of Michigan and Bureau of Labor Statistics

The University of Michigan’s consumer sentiment index tumbled by 5.5 points in the mid-May reading, its largest decline in ten months, as inflation expectations shot higher. Specifically, respondents to the survey anticipated that prices would rise by a median 4.6 percent over the next 12 months, up from 3.4 percent in April and the highest expected inflation rate in more than a decade.

It should come as little surprise that inflation expectations are soaring given that price pressures themselves are percolating. In fact, consumer price expectations have historically correlated strongly with the prevailing inflation rate while exhibiting relatively modest predictive power. The UM survey has missed the mark on the one-year forward inflation rate by an average of one full percentage point and has overshot the actual number in each of the last nine years.

Not surprisingly, bigger swings in inflation have produced larger forecast misses. Some of this owes to the inherent unpredictability of energy prices, but note that expectations have also consistently overestimated core inflation in recent years, albeit to a slightly more modest degree than relative to the headline index.

The experience of the last cycle is instructive. Consumer inflation expectations hit 4.6 percent in early 2011, as prices were in the process of resetting higher in the wake of the 2007-09 recession. Of course, this would prove to be a short-lived spike; by the spring of 2012, the inflation rate was again well south of 3.0 percent and would remain below that mark for the remainder of the expansion (expectations would be slow to catch up, not falling sustainably below 3.0 percent until late 2014). This is far from a perfect corollary to the current environment given COVID-related dislocations, but base effects and post-pandemic normalization should make for a similar, if more acute, pattern. The inflation rate may well remain elevated for some time, but it will be hard pressed to match the current median consumer forecast for this time in 2022.

Daily Trivia

What country temporarily pushed its highest marginal tax rate above 100 percent in the 1970s, inspiring the satirical story “Pomperipossa in Monismania”?

Previous Question

What 19th century breakthrough, developed by three economists working independently to explain consumer behavior, is considered the dividing line between classical and modern economics?

Answer:

The Marginal Revolution