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Central banks<\/a> are assessing whether rising energy costs will drive broader inflation<\/a>. FRANKFURT\/WASHINGTON \u2014 The world\u2019s central bankers may be attempting the impossible: to get into the psyche of business executives, labor unions and ordinary households in real time to understand how they are navigating their finances through yet another energy shock<\/a>.\n<\/p>\n Policymakers are contemplating whether to jack up interest rates<\/a> to combat rising inflation. But they will only pull the trigger if they think a surge in energy costs induced by the Iran war will filter into other prices, lifting inflation expectations across the entire economy.\n<\/p>\n The problem is that measuring such expectations is notoriously difficult. Central banks have a trove of surveys, gauges and indicators at their disposal but all of them have blind spots if not outright faults.<\/p>\n Since the COVID-19 pandemic, they have developed new tools to fill gaps in data about behavior. But measuring expectations remains more an art than an exact science.\n<\/p>\n That could raise the bar for rate hikes as policymakers are wary of gut-feeling decisions and usually prefer to wait for more evidence to narrow the risk of a policy error.\n<\/p>\n Behaviors have changed since 2022 inflation spike<\/p>\n Policy-makers at the Bank of Canada<\/a> acknowledged that global uncertainty meant they \u201cwould need to rely on judgment more heavily than usual\u201d to plot the path of economy, according to minutes of its March 18 meeting at which it kept rates on hold.\n<\/p>\n Others describe the effort involved in the process.\n<\/p>\n \u201cI try hard to get into the thoughts of price-setters and how they are seeing it \u2014 trying to calibrate their confidence in pricing power,\u201d Richmond Federal Reserve Bank President Tom Barkin told Reuters.\n<\/p>\n \u201cThe \u2018hike\u2019 case would be around inflation expectations starting to finally move,\u201d he said. \u201cI don\u2019t have a sense that they\u2019ve broken out at this point.\u201d\n<\/p>\n One complication is that behaviors change.\n<\/p>\n In 2022, consumers and firms had little experience with rapid inflation, making price- and wage-setting a rather rigid exercise.\n<\/p>\n \u201cBut now people have lived through a painful episode of inflation, and this may mean that inflation expectations are more fragile, and so they could be more sensitive to such an energy price shock,\u201d European Central Bank<\/a> board member Isabel Schnabel said in a university lecture on Friday.\n<\/p>\n For companies, changing their selling prices was a cumbersome process before the pandemic and so they limited adjustments, often to once a year. This became untenable and the frequency of changes sky-rocketed, Schnabel argued.\n<\/p>\n This makes the frequency and not just the magnitude of such changes a good indicator that expectations are shifting.\n<\/p>\n Traditionally, central banks relied on surveys and market indicators to assess expectations. But surveys are not done frequently enough to capture rapid changes and their time horizon is often out of sync with that of policymakers.\n<\/p>\n Market indicators of expected inflation are also imperfect because they include the extra return, or risk premium, investors demand for holding a particular financial instrument. This changes with market sentiment, blurring shifts in actual price expectations.\n<\/p>\n
\nPolicymakers face challenges measuring inflation expectations<\/a> in real time despite new tools and data.
\nBehavioral shifts since the 2022 inflation surge make price and wage trends harder to predict.
\nRate hike decisions hinge on whether inflation expectations rise as the Iran war keeps energy prices elevated.<\/p>\n