When inflation was headed to a 40-year peak in June of 2022, Americans broadly underestimated how high it would go. But now that inflation is falling, people expect it to be higher than it will probably turn out to be.
The latest inflation report shows that price hikes are abruptly cooling, with the annualized inflation rate dropping from 3.7% in September to 3.2% in October. Markets cheered, with stocks soaring on expectations that the Federal Reserve will be able to stop raising interest rates as inflation gets closer to its 2% target.
Consumers are grumpier, however. In the latest University of Michigan sentiment survey, respondents said they expect inflation to be 4.2% a year from now, which is a full percentage point higher than inflation is now. That’s also a lot higher than what most economists expect. Moody’s Analytics, for instance, forecasts that inflation will gradually drop to around 2.5% a year from now, more than a point and a half below the consumer outlook.
There’s a big difference between the 4.2% inflation consumers expect a year from now and the much lower 2ish number economists are looking for. If inflation drops slightly from current levels, it means the trend is going in the right direction and the Fed will be able to sit tight. But if inflation reverses its downward course and starts going back up, the Fed may have to hike interest rates even more, rattling the stock market anew and sending the message that the Fed’s medicine isn’t working, after all.
Obviously most consumers don’t run econometric models to forecast their own personal rate of inflation. But the amount of inflation consumers expect is still important, because it affects their economic behavior and even influences what the Fed does. Consumers who expect high inflation in the future might be more willing to spend money now to lock in prices while they’re lower. The converse is also true: Consumers might be reluctant to spend today if they think prices will be lower in the future.
Consumers—like economists, to be fair—have been flummoxed by the rapid rise and fall of inflation during the last two years, as the following chart shows. Inflation was benign until the middle of 2021, when it began shooting up. But consumers didn’t see it coming. They expected inflation to be anchored around its familiar 2% range when it was actually soaring to nearly 9%.
Now that inflation has been falling, the expectation mismatch is reversed. In March of this year, inflation fell below the level consumers expected, and it has remained below ever since. There may be some psychological scarring in those numbers. It took consumers a while to believe inflation was going as high as it did, but now that it’s coming down, they don’t want to believe that, either.
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This is more than a game of pin the tail on inflation. Rising prices have been President Biden’s biggest economic problem, and voters give Biden poor marks on the economy, even though growth has been strong and the job market is solid. Prices rising by more than incomes has put Americans in a recessionary mood, and they blame Biden, which is why his approval rating has been stuck at a weak 40% or so ever since inflation hit its high point last year.
Inflation, in fact, may be the single biggest barrier to Biden’s reelection. In a recent Yahoo Finance-Ipsos survey, 66% of respondents said they expect inflation to go higher during the next 12 months, while only 11% said it would go lower. That’s consistent with the Michigan inflation expectations. In a separate question on the Yahoo Finance-Ipsos survey, 56% said they expect the economy to get weaker, while 43% said it will get stronger or stay the same. Consumers think the economy’s in bad shape and they don’t think it will improve, which is obviously bad news for Biden.
You could flip this around and conclude that things are going Biden’s way, with inflation falling back toward a normal range just as the next election heats up. The only missing piece is that consumers don’t buy it. So all Biden has to do is keep hammering the message that inflation is declining and everything is getting back to normal and hope voters start to believe it by the time they decide whether to give him another four years.
The lesson in the numbers, however, is that inflation is a searing experience consumers don’t quickly forget. People may seem inordinately gloomy right now, but the message they’re sending is that they’re still hurting.
Rick Newman is a senior columnist for Yahoo Finance. Follow him on Twitter at @rickjnewman.
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