What to expect when you're expecting inflation — or recession

What to expect when you're expecting inflation — or recession
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Is the economy doing great or are we headed toward a recession? One can find evidence for just about any view these days. The latest set of somewhat contradictory signals comes from inflation expectations.

Economists, despite decades of applying improved mathematics, statistics and computing power, still labor mightily to predict where the economy will go. One thing is clear: Both companies and households make decisions based on their ideas about the future, even if most of us do not spend much time studying such matters.

For example, if you talk to your boss about a pay raise, you may have many things on your mind: How much your current bills are, that new car that you will have to buy, how much you will spend for health insurance and a whole range of other concerns.

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Whether you are aware of it or not, your pay request will reflect what you expect to happen with all of these very down-to-earth items. And you certainly have ideas about that!

You might object that most of us look at what has happened recently, and use that as a basis for our requests. Fair enough. Still, economists can and do try to attach a number to this.

Since most people’s perceptions of inflation are not terribly precise or systematic, economists try many different approaches to get inside people’s heads. Direct surveys represent the most important way, although different surveys ask different questions, each striving to get a more reliable handle on how people view future increases in costs.

What does this have to do with recession? The basic idea in macroeconomics is that, as the economy gets stronger and more people have jobs, inflation will rise. Similarly, when the economy weakens or goes into a recession, inflation will fall, as people are less inclined to spend and companies feel less pressure to accede to pay increases.

This idea has guided macroeconomic thinking, especially for central banks, since the 1960s at least. But the recovery from the Great Recession of 2007-09 has not fit this pattern very well.

The economy has grown, not at a spectacular rate but fairly steadily, the whole time. Unemployment has fallen to levels not seen since the 1960s, but wages just have not been rising very much at all.

Most central bankers continue to worry that wages will take off. There are plenty of stories out there about professions where qualified workers are hard to find. There are also stories about parts of the country where available workers are nowhere to be found. Simple logic says that workers who are willing and qualified should be getting nice raises by now.

Which brings me back to the headline that provoked this piece. The New York Fed just released its Survey of Consumer Expectations. The Fed asks a large sample of ordinary folks how much inflation they expect in the next year and the next three years. Both figures fell in May, continuing a trend that started at the end of last year.

This might sound good; lower inflation means we won’t have to spend as much next year as we might have thought. But going back to the wage-inflation connection, also called the Phillips Curve, this steady downward movement in inflation expectations strongly suggests a weakening economy.

N.Y. Fed President John Williams discounted the data a bit, saying that he still expects inflation to rise in the coming months. Indeed, another widely respected indicator of inflation expectations, the Cleveland Fed’s 10-Year Expected Inflation, bumped up very slightly to 1.8 percent in May after declining steadily since last November.

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What's more, the Dallas Fed’s Trimmed Mean indicator, yet another take on where inflation is likely to go, has stayed pretty steady.

So many Feds, so many indicators! And I didn’t even discuss all that are out there. Economists love to look at lots of data, but sometimes the results provide more noise than clarity.

All in all, despite trade wars and stock market turbulence, we do not have anything that would unambiguously tell us a recession is near at hand — yet. But with Fed Chair Jerome Powell signaling that the next move for the Fed is most likely a rate cut, a recession is definitely more of a concern than rising inflation for now.

Predicting the onset of a recession is often a thankless task. But this time, the incoming information just does not look like anything we have seen before. And the unprecedented whipsawing the economy gets almost daily from the White House does not make prognostication easy. My only clear message is: Keep watching the data, follow expectations, but expect the unexpected.

Evan Kraft is the economist in residence for the Economics Department at American University. He served as director of the Research Department and adviser to the governor of the Croatian National Bank.