A crucial part of the central bank's inflation fight is to manage inflation expectations. More important than today's inflation, inflation expectations alter behaviors, amplify trends, and set the path of future inflation. How does the Fed manage inflation expectations: by committing to a inflation target, clearly communicating its reaction function, and staying consistent. When inflation expectations are well-'anchored', they are less sensitive to incoming data, giving policymakers more room and freedom to balance other factors and achieve a better outcome.
This dynamic has played out this year. Despite the noises around inflation and jobs data, the ICE U.S. Dollar Inflation Expectation for the next 12-month, derived from TIPS, Treasury Bills, Notes and Bonds, and inflation-linked swaps, has stayed in a tight range between 2-3%, allowing the Fed to respond less aggressively to the uptick in look-back inflation amid the banking turmoil. In turn, the Fed hiked another 25bp in March to maintain its credibility and reinforce market perceptions.
Well-anchored inflation expectations in the last eight months are in stark contrast to the runaway expectations from late 2021 to mid-2022. When the Fed was sticking to the 'transitory' talking point, inflation expectations hopped on a fast-rising trend and reached multiple highs above 5%. It took the Fed four months and three hikes in 2022 to convince the TIPS and inflation swap traders of its determination to battle inflation. Forward 12-month Inflation expectation plummeted from 5.14% in mid-June to 1.76% in a matter of forty days.
Since then, realized inflation amounts to 2.3%. If monthly inflation averages to 0.3% for the next four months, we are on track to have 12-month inflation from July to June right around the implied inflation of 3.45% at the end of June 2022.
Tomorrow, the February readings of the Fed's preferred inflation gauge, PCE, will be released and are expected to stay elevated. But what can the range-bound inflation expectations tell us? One, real-time inflation may still be high, but the Fed has made nontrivial progress in harnessing inflation expectations. Two, the Fed will continue seeking to maintain credibility in order to keep inflation expectation properly anchored, as they did in March. Three, based on the current market-implied inflation expectations, inflation ahead is likely to be much lower than it is now, which should give the Fed more flexibility and increase its odds to achieve the dual mandate.