Last month, the Federal Reserve wrapped its first meeting with Jerome Powell’s replacement, Kevin Warsh, at its head. The target rate remained unchanged at 3.5% to 3.75%, and the minutes, released a few weeks after the meeting, mostly read the way Federal Reserve minutes always do — very dry.
But within them was an 11-word warning that investors should pay attention to now. Years of above-target inflation “could begin to affect inflation expectations and wage- and price-setting decisions.” That may be dry central-banker language, but it could have major ramifications for the S&P 500 (SNPINDEX: ^GSPC).
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Here’s how.
Why the Fed is worried about inflation expectations
The Fed’s 2% inflation target works because people believe in it. When they stop believing, inflation starts feeding itself — workers push for raises to stay ahead of prices, and businesses raise prices to cover the bigger paychecks. The cycle repeats.
Economists call this a wage-price spiral. Once people expect higher prices, it becomes self-fulfilling.
Now, we’ve had several years of inflation well above 2% — the Consumer Price Index was more than double that in May at 4.2%. Though June’s reading (released after the meeting in question) fell to 3.5%, there’s a real threat that the public may be starting to adjust, believing that inflation is here to stay.
Many businesses have told the Fed they’re under real pressure and are weighing how much of the rising costs to pass along to customers.
The 1970s wage-price spiral: a cautionary tale
In the 1970s, after a decade of extremely hot inflation and half-measures, the public simply assumed prices would keep climbing and set wages and prices accordingly. The job of finally stopping the vicious cycle fell to Fed chair Paul Volcker.
Image source: Getty Images.
The Volcker Fed pushed the federal funds rate to 20% in 1981, causing a recession as unemployment climbed to 10.8%, the worst since the Great Depression. It worked, though. Inflation fell from more than 14% in 1980 to 3.5% a few years later.
Researchers later concluded that roughly half of that improvement came from something more abstract than the numbers themselves — people simply started believing the Fed could actually get control of runaway prices.
Why the 2022 inflation spike didn’t become a crisis
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