A shadow of doubt has been cast over the Federal Reserve’s ability to hit its inflation target after the latest Consumer Price Index (CPI) numbers came in hotter than expected. The CPI, a widely-used indicator for inflation, rose 0.3% over the previous month and 3.1% over the prior year in January, signaling continued price pressures in the US economy. The increase came in higher than December’s 0.2% rise and the market’s prediction of 0.2%.
Excluding the volatile food and energy components, core CPI saw an even larger increase of 0.4% in January and a 3.9% rise over the previous year. Core CPI, which is considered by many economists as a better reflection of underlying inflation trends, has now exceeded the Fed’s target for nearly three consecutive years, raising questions about the Fed’s ability to control inflation.
Inflation is like the heartbeat of an economy — its pace and rhythm are often viewed as one of the key indicators of its health. The Fed’s target of 2% inflation has long been seen as the sweet spot for a healthy economy, signaling enough growth and demand to keep the economy humming but not so much that prices spiral out of control. However, the path to achieving this target has been anything but straightforward. Despite the Fed’s best efforts to curb inflation through its aggressive rate-setting policies, January’s CPI data suggests that reaching its target may be more challenging than expected.
As the global economy becomes increasingly interconnected and complex, the traditional relationship between inflation, the money supply, and economic growth has become less clear. Shifts in consumer behavior and technological advancements have changed the way money moves through the economy, making it more difficult for central banks to predict and control inflation. At the same time, anchored expectations and market psychology, as well as demographic changes and structural shifts in the labor market, have added new layers of complexity to the inflation equation.
With years of loose monetary policy setting the stage for persistently high inflation and unpredictable market forces at play, some experts argue that the Fed’s target of 2% may no longer be an achievable goal. Others suggest that the Fed should consider a new framework for targeting inflation, such as average inflation targeting or price-level targeting, to better reflect the current economic landscape.
Regardless of the approach, one thing is clear: the Fed’s task to maintain price stability and support economic growth has become increasingly difficult in the face of these changing dynamics. Sticky inflation continues to pose a threat to American consumers, forcing many to make tough choices about spending and savings. With businesses hesitant to lower prices even in the face of weaker demand, the Fed’s traditional methods of controlling inflation may not be as effective as they once were, which begs the question: Is high inflation the new normal?
Gauging Americans’ Inflation Expectations
Inflation expectations play a pivotal role in the actual inflation outcomes, often acting in a self-fulfilling manner. When individuals and businesses anticipate higher inflation, they tend to adjust their behavior accordingly — workers bargain for higher wages, and businesses set higher prices, ostensibly to preserve their purchasing power and profit margins. This anticipatory action, in turn, can impart upward pressure on the overall price level, contributing to the inflation they initially sought to mitigate.
The feedback loop between expectations and inflation is a well-documented phenomenon in economics, with inflation expectations acting as a driver of inflation dynamics. But it’s not just prices and wages that are affected. Research indicates that the inflation expectations of businesses also impact their investment and hiring decisions, both of which have a direct impact on the overall economy. At the same time, expectations held by households can influence their spending and saving habits, affecting the overall demand for goods and services.
So, what do Americans expect from inflation? A recent University of Michigan consumer sentiment survey revealed that consumers’ inflation expectations have jumped to the highest level since 2011. Over the course of the next five to ten years, survey respondents expect inflation to average 3.2% per year — well above the Fed’s long-term target. A separate survey conducted by the Federal Reserve Bank of New York found that consumers’ expected inflation rate over the next one-year period is also above the Fed’s target, at 3.0%. While expectations have moderated from 2022 levels, they remain elevated compared to pre-pandemic levels, a sign that Americans may be adjusting to a new normal of higher inflation.
This sentiment has also been reflected in the consensus view among economists, with many predicting that inflation will remain at elevated levels for the foreseeable future. A recent Survey of Professional Forecasters, conducted by the Federal Reserve Bank of Philadelphia, found that the median forecaster expects Personal Consumption Expenditures (PCE) inflation to settle at around 2.5% over the next five years. Despite financial markets pricing in a more rapid decline in inflation, Americans and economists alike seem to be preparing for a longer period of elevated prices.
The Four Ds and Sticky Inflation
Apart from inflation psychology, economists point to the “Four Ds” — demographics, debt, deglobalization, and decarbonization — as key factors that could contribute to elevated inflation in the years ahead. These structural changes, combined with sticky inflation, where price increases become entrenched and difficult to reverse, could mean that a 3% inflation rate or higher may become the new normal for the US economy.
Demographics
Shifts in demographic patterns have historically shaped economics, and the current trend toward aging populations in many developed countries is no exception. Since the 1960s, the US has experienced a demographic dividend due to its large population of baby boomers, with the median age increasing from 29.5 in 1960 to 38.9 in 2023. As this cohort aged, savings increased and consumption declined, contributing to a reduction of inflation by 5% between 1975 and 1990. However, as the baby boomer generation continues to withdraw from the workforce, the demographic dividend once enjoyed by the US is set to turn into a demographic drag.
Source: Investopedia
Consistent with the life-cycle hypothesis, individuals tend to spend more after retirement as they have more time to consume, leading to higher demand. This, according to the demand-pull theory, can lead to inflationary pressures as demand outpaces supply.
Debt
US national debt has skyrocketed in recent years, with the country’s total debt now exceeding $34 trillion. At a cost of about $100,000 per person, mounting debt has become a contentious issue among policymakers and economists alike, with some arguing that it could lead to long-term economic consequences if unchecked. As debt levels rise, there is an inherent expectation of increased inflation rates over time. This is because central banks often resort to printing more money to pay off debt, which leads to an increase in the money supply. As Nobel Prize-winning Economist Milton Friedman famously said, “Inflation is caused by too much money chasing after too few goods.” In other words, the higher the amount of money in circulation, the less valuable each individual unit becomes. With more money chasing the same number of goods, prices naturally rise while global confidence in the US dollar continues its descent.
Deglobalization
The era of globalization has been a major driving force behind global economic growth in the last few decades. However, the trend towards deglobalization has been gaining traction in recent years, with the pandemic only accelerating this shift. Deglobalization refers to a reversal of the free flow of goods, capital, and labor across borders that has characterized the global economy for decades. As countries prioritize their domestic industries, globalization has taken a backseat, with trade barriers and protectionist policies on the rise. Add to the mix of growing national security concerns and rising nationalism, and the global economy may be on the verge of a major shift.
With countries retreating from globalized trade in favor of prioritizing domestic markets, experts warn that operating costs for businesses are likely to increase. Trade tariffs and barriers not only make goods more expensive for consumers but also create inefficiencies in supply chains, leading to higher production costs. As a result, consumers may end up paying more for products that were previously sourced from cheaper foreign markets. There’s also the potential for a loss of operational efficiency due to a reduction in economies of scale and increased bureaucratic red tape as firms navigate a more fragmented trade environment. With businesses facing higher costs, experts say consumers will likely bear the brunt of these added expenses as companies pass them on in the form of higher prices.
Decarbonization
Economists say that short and long-term inflationary pressures may also be exacerbated by global efforts towards decarbonization. The push for decarbonization is a double-edged sword for the economy—with the short-term side effect being an uptick in inflation due to substantial investments needed to initiate the transition. As both private and public sectors pour capital into renewable energies, electric vehicles, and low-carbon heating solutions, this influx acts as a direct stimulus, driving economic growth.
This growth spurs an increased demand for labor and materials, intensifying pressures across supply chains and contributing to demand-pull inflation. While these investments promise a payoff for investors, the costs often trickle down to consumers, further inflating prices. And if emissions taxes fall short of covering the hefty financial requirements, the government may resort to raising taxes to bridge the gap, perpetuating the cycle of rising price levels and ongoing inflation.
The Power of Precious Metals
In light of the sticky inflationary environment and structural pressures on the economy, experts say precious metals like gold and silver can play a valuable role in helping Americans protect their wealth. Unlike fiat currencies that are prone to devaluation, precious metals have a finite supply with intrinsic value that has stood the test of time. As inflation erodes the purchasing power of fiat currencies, these metals have historically held their value and even appreciated in times of economic uncertainty. With 3% inflation looking like the new normal and the possibility of higher inflation rates looming, diversifying one’s savings with these tangible assets could provide a much-needed hedge against the risk of rising prices.
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