We have previously argued that the lowest volatility quintile contains information on the inflation expectations of infrequent price-setters. We argued further that expectations are the forcing variable for the Fed — allowing us to predict the Fed’s response under forcing as long as we’re picking up the signal. Recall that a signal is a pattern that contains causal information about the world. We need some data realism. We’re free to ignore noise; not signal. Even if my interpretation that the lowest volatility quintile contains information on inflation expectations of brick and mortar price-setters is incorrect, you can think of it as a robust, slow-moving estimator of underlying inflation.
I have some bad news and some good news. On the one hand, expectations are no longer getting further deanchored and have stabilized. On the other, our expectations signal has stabilized at 5.4% per annum — 3.4% above target. So, there’s “a long way to go” before the Fed can let up. (Note that we’re cumulating mean monthly returns across the lowest fifth of the prices by volatility and detrending by computing rolling 12-month percentage returns.)
We look closer at the recent past. July came in at 5.42%, a shade above 5.40% in June. Technically, our expectations barometer is still climbing and is, as a matter of fact, higher than it has been since at least 2003. There’s still ways to go before the fed can let up. But the good news is that the rate of growth of inflation expectations has collapsed. There seems to be a glimmer of light at the end of the tunnel.
There is an argument to be made that the 2% is too low. 3-4% seems fine if it means keeping labor markets tight.