Inflation expectations, Jerome Powell and what economics tells us about them:

Most economic models of price setting have some form of ‘inflation expectations’. Inflation expectations relate to what price setters think inflation will be in the future and long run.

Inflation expectations are often a ‘belief’ driven concept - that is, the price setter believes inflation will be kept at x% (typically 2%), by the Central Bank.

Inflation expectations, in economic models, can be treated as an ‘exogenous’ variable (i.e. it is determined outside the model), or an ‘endogenous’ variable (i.e. the model influences the variable). Naturally, the second case is more interesting, because things like historic inflation can influence your expectation (as is the case in real life).

Nearly all economic models relate today’s inflation to inflation expectations. How inflation expectations impact today’s inflation is called the ‘pass-through’ rate of inflation expectations. That is suppose you expect inflation to be 0.5 percentage points higher than the 2% base line. If there’s no pass through, then this won’t effect inflation today. If there’s one-to-one pass through, then 0.5 percent will increase today’s inflation by 0.5 percent. If there’s ½ to 1 pass through, then 0.5 percent higher expectations will increase today’s inflation rate by 0.25 percentage points.

Almost all economic models have a pass-through rate between ½ and 1.

When Jerome Powell talked about inflation expectations ‘unanchoring’, this was his worry. Suppose people would believe that inflation in the future will 6%. Then today’s inflation will be at least 3% and as high as 6% due to the pass-through of expectations. Thus, Jerome Powell focused on keeping the expectations ‘anchored’.

However, at the same time, we do not have a perfect method of guaranteeing anchoring. How high must the central bank raise rates to keep inflation expectations anchored is a question without precise answers.

This is where putting too much weight on anchoring inflation expectations can be risky, as you may hold interest rates high too long, which weakens the economy too much. Moreover, expectations themselves (unless they become aggressively unanchored) are unlikely to be a problem regarding keeping inflation in check.