The Big Idea
Inflation expectations at a critical level
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Inflation is accelerating, and Fed officials, economists, and financial market participants are debating the relative importance of persistent underlying pressures compared to temporary tariff-related price hikes, with the energy price spike introducing another complication. The critical question is whether inflation will quickly revert to the 2% neighborhood once these temporary influences fade or whether the seemingly endless string of supply shocks will change the way that businesses and consumers view price setting, promoting a higher inflation trend. Consumer surveys asking about inflation predictions suggest that we have reached a critical point on longer-term expectations. Further increases from here will be especially problematic for the Fed.
Setting the stage
The textbook treatment of a temporary inflation force, such as a one-off wave of tariff-related price passthrough or an energy price shock, is that the central bank should ignore it and concentrate on the longer-term underlying inflation trend. This strategy worked numerous times in recent decades when inflation surged due to energy price shocks, such as when hurricane Katrina knocked out oil refineries.
However, the strategy backfired on the Fed in the aftermath of the pandemic, when a wave of supply restrictions pushed prices higher. Chair Powell and others at the Fed confidently declared that the ensuing inflation would prove “transitory.” What they missed is that the Fed had injected far too much liquidity into the economy, turning what might have indeed been a temporary adverse supply shock into an economy with grossly excessive demand at the same time that supply was constrained.
We find ourselves at a critical crossroads at the moment with regard to inflation. Having brought inflation back down to between 2.5% and 3.0% on a year-over-year basis by 2024, the Fed was optimistic that it would soon achieve its 2% target. However, progress stalled out at that point. Officials spent most of 2025 blaming too-high inflation on tariff-related passthrough and asking for patience. As we entered 2026, the continuing lack of progress on core inflation had some Fed officials beginning to grow restless.
More recently, layering on top of the ongoing tariff effects, energy prices spiked due to the repercussions of the conflict in the Middle East. Again, the traditional playbook calls for the Fed to look past these temporary effects. However, as a number of more hawkish policymakers have pointed out, that strategy presumes that the special factors will be generally viewed as strictly one-off.
In the current circumstances, when businesses and consumers have faced a seemingly endless series of adverse supply shocks beginning with the pandemic in early 2020, there is a risk that price setters (businesses) and price takers (consumers) will begin to regard supply disruptions as a common feature of the economic landscape and will incorporate them into inflation expectations. At that point, when what would formerly have been thought of as an anomaly becomes par for the course, the Fed (or any central bank) has a problem.
The question currently facing the FOMC is whether we are nearing that point in the US economy.
Consumer survey inflation expectations gauges
There are two consumer surveys that regularly ask households about their longer-term inflation expectations. The University of Michigan consumer sentiment survey has been asking about 1-year-ahead and 5- to 10-year-ahead inflation expectations for several decades. More recently, the New York Fed began publishing 1-year-ahead and 3-year-ahead inflation expectations in the early 2010s. The New York Fed also began reporting 5-year-ahead figures but only in 2022, leaving not enough history to be useful in this context. All of the figures described below represent the median responses of households.
The recent history of the University of Michigan long-term (5- to10-year ahead) inflation expectation series is a bit surprising (Exhibit 1). The pre-pandemic norm was for this series to fluctuate at or below 2.5%. Recall, though, that this was a period when inflation ran on average modestly below the Fed’s 2.0% target. Perhaps the 2.5% to 3.0% range seen for much of the 2000s and early 2010s is a better range for tracking with actual inflation in the 2.0% vicinity. What is interesting is that longer-term inflation expectations never substantially exceeded 3.0% in the post-pandemic period, despite actual inflation peaking at close to 7.0%.
Exhibit 1: University of Michigan longer-term inflation expectations
Source: University of Michigan.
In contrast, in the runup to and aftermath of the Liberation Day tariff announcement last year, longer-term inflation expectations spiked, reaching as high as 4.4% in April before quickly receding to the low 3.0%’s by the end of last year.
Note that, historically, December’s 3.2% reading was probably already too high to be consistent with actual inflation of 2.0%. The April figure, however, jumped from 3.2% in March to 3.5%, the highest level, aside from a handful of readings last year, in 30 years.
The evolution of the New York Fed’s 3-year-ahead survey during the 2020s is quite different, and more plausible in my view (Exhibit 2). Inflation expectations surged as actual inflation ballooned, peaking in 2021 at over 4.0% compared to a pre-pandemic norm of 2.5% to 3.0%. Fortunately, inflation expectations quickly receded, sliding back to the pre-pandemic prevailing range by 2024. Liberation Day elicited a small and brief uptick in expected inflation, but the series has generally been parked at 3.0% since the beginning of last year.
Exhibit 2: New York Fed 3-Year-Ahead Inflation Expectations
Source: NY Fed.
Unfortunately, the gauge crept higher in March and April, reaching 3.15% last month. This reading is not far from the previous prevailing level of 3.0%, but it is the highest in a decade aside from the single 3.2% figure in April 2025 and the post-COVID surge in 2021 and 2022.
Conclusion
The relatively small uptick in longer-term inflation expectations in the last few months is not out of line with prior episodes when oil prices spiked and, by itself, is not necessarily terribly alarming. However, a further significant ascent from here would take these gauges to rarely seen levels. Such a result would signal a danger that the fears of some policymakers that consumers are recalculating their views of what is normal for inflation in a way that will make it far more difficult for the Fed to achieve its 2.0% inflation target.
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