The power of expectations!

There is a core belief in psychology that expectations can change a person’s behavior, the expectations can be imposed externally (by another person) or internally (one’s own belief). This tenet in psychology has played out in the financial markets for some time, and is getting reinforced now. One of the key reasons why inflation consistently stayed below the Fed-targeted 2% in the post-GFC era was because market participants were convinced about Central Bank’s ability to control inflation. Expectation of Central Bank success (in controlling inflation) led to low inflation expectations, and market participants changed their behavior in light of those low inflation expectations, and in-turn led to actual inflation remaining low.

On 8/27/20, Federal Chairman Powell made a key statement that changed the markets’ expectation. He clearly stated that instead of the 2% being the target in terms of a level, he wants to keep 2% as an average. This implies accepting periods of time (he did not clarify the length of this time-period) where inflation can stay above 2%. Knowing that the Fed will allow inflation above 2% will change market perceptions of what is possible and therefore what can be/might be. This change in market expectation could possibly contribute as much or more to increasing inflation than may be seen from post-Covid supply chain disruptions and trade inefficiencies.