Perception is reality: households still don’t expect rising prices

Financial markets and economists in general anticipate increasing levels of inflation stemming from President-elect Trump’s proposed fiscal stimulus policies.

To be sure, at Morgan Stanley, we’ve upwardly revised our forecasted path for inflation in our 2017 Year-Ahead Outlook, which incorporated our own post-Trump assumptions.

{mosads}While the consensus among economists expects higher inflation, financial market participants have also sharply adjusted.

Indeed, market-based measures of inflation expectations, expressed in “breakevens” — the difference between the nominal yield on a Treasury bond and a Treasury Inflation Protected Security (TIPS) of the same maturity — have soared since the presidential election. 

Much ado has been made about the future path of inflation as President-elect Trump’s policies are largely expected to deliver stimulus spending late in the business expansion with less slack in the economy.

Running a higher pressure economy can lead to sharper inflationary pressures. This, in turn, may lead monetary policymakers to raise interest rates more quickly as the ever-elusive 2 percent inflation goal finally looks achievable.

We now expect the Federal Open Market Committee (the Fed) to hike interest rates twice this year, doubling its pace from just once yearly in 2015 and 2016.

While financial market participants and economists anticipate higher prices, America’s households do not. In fact, surveys of households reveal that inflation expectations have fallen since November.

One such survey from the Conference Board shows that, since the presidential election, households believe inflation will be lower a year from now than it is today. In fact, the measure recently dropped to its lowest level since early 2005.

Why? At the same time that household expectations of inflation have fallen, their expected future income has jumped sharply.

In the same survey from the Conference Board, the measure of households expecting higher income has shot up to its highest level since late 2006.

Higher income can make the things we purchase feel cheaper, even if prices are not falling. The increase in expected income is built on the promise that President-elect Trump will deliver on tax reform.

A Funny Thing Happened on the Way to the Grocery

Sometimes, it’s all about perception. Perhaps you went to the grocery store and felt crimped to cover the bill last month, but get a raise and next month that exact bill suddenly feels cheaper.

Even if the raise has not yet come through (just as promised tax cuts have not yet been delivered), the anticipation of higher income may make that same grocery bill easier to stomach today.

This is exactly the dynamic that has been captured in consumer surveys since the presidential election. Falling inflation expectations among households are less a reflection of expected prices and more a reflection of anticipated gains in income.

This is an important development in the outlook for the economy because how we feel about our future finances tends to dictate how we spend today.

To be sure, if households front-run the expected tax cuts, we may see consumer spending rise well before they are scheduled for delivery.

Perhaps this has already begun — in December, the annual pace of vehicle sales jumped to the highest level since 2005.

On the back of rising income expectations, buying plans generally have increased. According to the University of Michigan Survey of Consumers, consumers gauge buying conditions for large household goods to be the best since mid-2005.

When asked why now is a good time for these large purchases, the highest scores were given to “prices are going higher” and “borrow-in-advance of rising interest rates”, as well as a general assessment that “times are good” (which has actually hit its highest mark since 2000!).

House of Cards

Equally important for the economy, expectations must be met for the positive post-Trump inflection in financial markets and household sentiment to be sustained.

At its December meeting, nearly all participants on the Federal Open Market Committee indicated that upside risks to growth had increased on the prospects of a more expansionary fiscal policy, but there also seemed to be an undercurrent of discomfort that, should those lofty expectations go unrealized, sentiment can unwind in a disorderly way that threatens the viability of the economic expansion.

Indeed, if expectations are built on a house of cards that comes crashing down, then, at best, we revert to the lackluster economic expansion we’ve been mired in for years; while, at worst, the expansion is cut short as demand that was pulled forward unwinds.

Ellen Zentner is the chief U.S. economist at Morgan Stanley. 

The views expressed by contributors are their own and not the views of The Hill.