Long-Term Inflation Expectations Surge Amidst Tariff Concerns
U.S. consumers' long-term inflation expectations have reached a nearly three-decade high, fueled by fears that President Donald Trump's tariffs will lead to higher prices.
According to the February reading of the University of Michigan survey, consumers anticipate an annual inflation rate of 3.5% over the next five to ten years. This marks the highest rate since 1995 and is primarily attributed to views among Democrat respondents.
Consequently, the consumer sentiment index has declined from 71.7 in January to 64.7, below analyst expectations. The results exhibit political polarization, with Democrats and political independents driving the downturn.
All five components of the index have deteriorated, including decreased buying conditions for major purchases. Over half of consumers surveyed expect the unemployment rate to rise in the coming year, the highest level since 2020.
Inflation expectations have taken on increased significance as trade war prospects cast doubt on future consumer prices. These concerns have dampened the sentiment index, partially reversing the post-election surge driven by Republican enthusiasm and expectations of easing inflation.
The uncertainty surrounding tariffs and their potential impact on consumer prices may influence interest rates. Federal Reserve officials have suggested they are reluctant to cut rates further in light of stalled inflation progress.
Over the next 12 months, inflation expectations have risen to 4.3% in the Michigan survey, the highest level since November 2023.
"The Fed's primary focus is achieving its inflation target, especially given the potential for tariffs to elevate price pressures," said Priscilla Thiagamoorthy, senior economist at BMO Capital Markets. "Unstable inflation expectations are the last thing the economy needs at this critical juncture."
Sustained growth in long-term inflation expectations would be particularly concerning to policymakers. Fed officials paid close attention to the Michigan survey in mid-2022. Despite differing circumstances, a spike in inflation expectations in June 2022, coupled with higher-than-expected consumer prices, prompted a 75-basis point rate hike instead of the anticipated 50-basis point increase.
"Elevated inflation expectations carry the risk of becoming self-fulfilling, as individuals and businesses tend to act on their beliefs," said Elizabeth Renter, senior economist at NerdWallet. "While the Fed has stated it will not react directly to hypothetical risks of unknown policy decisions, it remains attentive to how consumers perceive and respond to these risks."
Several Fed officials have indicated a willingness to overlook short-term price increases resulting from tariffs if inflation expectations remain stable. However, any suggestion that consumers foresee sustained price gains may necessitate rate hikes to curb inflation.
"It may be appropriate to ignore, or 'look through,' a price level increase if the inflationary impact is expected to be temporary and contained," said Alberto Musalem, President of the St. Louis Fed. "However, a different monetary policy response could be warranted if higher inflation persists or long-term inflation expectations escalate."
According to a separate report from the University of Michigan, long-run inflation expectations "exhibit substantial uncertainty, particularly in light of policy changes under the new presidential administration."
Economists also anticipate higher inflation. A Bloomberg survey of analysts reveals an upwards revision in forecasts for the Fed's preferred inflation measure for the first quarter compared to the previous month.
In other economic news, Friday's data indicated a slowdown in business activity in February, driven by the service sector. Existing-home sales also declined for the first time since September 2023, signaling a challenging spring selling season amidst high mortgage rates and prices.
The University of Michigan's current conditions gauge in the survey fell to 65.7 from 75.1, suggesting a deterioration in consumers' perceptions of their financial well-being.