Anchoring that didn’t happen

Recently, discussions among Wall Street analysts and Federal Reserve officials centered on the risk of inflation expectations becoming “unfixed” due to rising prices from tariffs. In October, the Federal Reserve Bank of Boston released a paper warning that household inflation expectations were rising inexplicably, echoing concerns from the late 1970s—a time when escalating expectations ignited an inflationary spiral.

This apprehension stemmed from established economic theories. In fact, the prevailing consensus among the Fed and many economists asserts that inflation expectations are crucial as they influence actual inflation. Essentially, if workers anticipate sharp price increases, they tend to demand higher wages to maintain their purchasing power. Similarly, companies may anticipate future higher costs for labor and inputs and react by raising their prices preemptively. This can lead to a cycle where inflation expectations feed into actual inflation, something Fed Chair Jerome Powell has highlighted as important to keep “anchored” around the Fed’s 2% target for price stability.

Are inflation expectations really that important?

However, there are valid reasons to question the extent of inflation expectations’ impact on actual inflation. In a provocative 2021 Federal Reserve staff paper, economist Jeremy Rudd argues that the widely accepted notion that inflation expectations drive inflation rests on a very unstable foundation. He meticulously scrutinized the theory, revealing that the models supporting it often rely on questionable assumptions or yield predictions that clash dramatically with data.

Rudd notes a scarcity of solid empirical evidence, asserting that the correlation between long-term inflation expectations and actual inflation trends might reflect rational responses from households rather than a direct causal relationship. His alternative perspective suggests that inflation dynamics depend more on the significance of actual price shifts during wage negotiations. When inflation hovers around 2%, workers usually don’t factor it into hiring choices, but once it escalates beyond 3 or 4%, it becomes a prominent concern during wage discussions. This distinction matters because if expectations don’t truly drive inflation, then attempts to “anchor” or manipulate them could misfire, resulting in heightened vigilance towards prices rather than easing concerns.

This theory, however, is not without criticism. There’s an inverse relationship between inflation and wage demands. Historical trends indicate that workers request higher wages not because they foresee future inflation, but because they are currently facing it. They seek better compensation to offset purchasing power erosion from existing high inflation. This narrative aligns with observations from past high inflation periods, where prices surged before wages followed suit slowly. Hence, it seems that the actual experience of inflation might take precedence over mere expectations.

Back to the 1970s?

Yet, from a monetary policy viewpoint, if the Fed perceives inflation expectations as significant, they are likely to act on that belief. So if they worry that those expectations could become unchecked, they may tighten monetary policy further to stave off rising inflation. Conversely, if they believe expectations remain stable, it might encourage a more accommodating approach, even with inflation remaining above target levels.

Researchers from the Boston Fed analyzed a consumer survey from the University of Michigan, noting that one-year inflation expectations had surged past 8% in March 2025. By employing a regression model to examine how households typically react to major price changes—especially gasoline and food—they found this spike alarming. In prior instances, like during the pandemic inflation of 2021-2022, much of the expectation rise correlated with actual price increases. However, in the spring of 2025, expectations soared beyond what could be justified merely by price shifts.

The findings mirrored the unsettling trends of the late 1970s. From 1973 to 1975, most of the increase in inflation expectations was aligned with actual price hikes, but from 1978 to 1980, those expectations drifted—only half could be traced back to pricing changes, indicating a worrying psychological shift. The March 2025 surge reflected a similar pattern to that period, with barely an eighth of the increase explainable by actual price movements.

This prolonged anxiety on Wall Street and within the Federal Reserve indicated that the tariff announcements in early 2025 could lead to not just a short-lived price shock but also a fundamental shift in American perceptions of inflation. If people began to anticipate persistent inflation, the Fed might find it necessary to maintain tighter monetary stances longer than anticipated, possibly leading to recession risks to manage expectations.

However, more recent data suggests a different reality. Even if such threats once loomed, they appear to have subsided.

Inflation expectations have had a ‘soft landing’

Research from Michigan illustrated that one-year expectations hit a peak of 6.6% in May but subsequently fell to 4.1% by December—a notable decrease of 2.5 points, or 38 percent from its high. More crucially, five-year expectations reached a high of just 4.4% in April, but returned to 3.2% in December, aligning closely with the December 2024 baseline of 3.0%.

Meanwhile, the New York Fed’s Consumer Expectations Survey presents an even more positive outlook. Three-year inflation forecasts rose slightly, from 3.0% in December 2024 to a max of 3.2% in April 2025, returning to 3.0% by November 2025. Throughout this period, long-term expectations remained relatively stable.

This trend starkly contrasts with the unanchoring seen in the 1970s, where expectations surged and persisted for years. Expectations did temporarily rise in 2025 amid tariff uncertainty but returned to normal levels within a few months. The spike was short-lived rather than indicative of a lasting change that concerned the Boston Fed.

The rebound to normalcy is particularly significant given that tariffs are still in place. If these tariffs were intended to fundamentally reshape American thinking about inflation, evidence suggests they failed. Consumers framed any price hikes related to tariffs as a one-time adjustment, not the onset of an inflation spiral—more like a shift in relative prices. This outlook was likely bolstered by the fact that, even for products believed to have increased in price due to tariffs, the hikes were often less severe than many analysts anticipated, balanced out by lower pricing trends in other sectors of the economy.

PCE data through September illustrates this well, as prices for durable goods (the category impacted most by tariffs) dipped for three consecutive months. Instead of fueling runaway inflation, tariffs have been absorbed without triggering knock-on effects.

So, in summary, the alarm bells from spring 2025 were overstated. Expectations reacted appropriately to a temporary shock. They spiked briefly but then stabilized back to normal.