The Unreality of Inflation Expectations

Inflation is not just about what prices do today. Inflation suffers from the self fulfilling prophecy of expectations. Inflation captures what people think they will do tomorrow. That’s why expectations play such a critical role in shaping the path of inflation. Even if headline numbers show inflation cooling, if households and businesses expect inflation to flare up again, they will behave in ways that make it harder to reduce inflation. Expectations drive wage negotiations, spending behavior, and business pricing decisions. They can either reinforce central bank credibility or undermine it, turning a temporary shock into something more persistent. Anchored expectations are the difference between a short-lived surge in prices and an entrenched inflation problem.

The Post-COVID Spike and the Stickiness Problem

The United States experience after COVID highlights the power of expectations. Inflation spiked as supply chains buckled, demand surged, and fiscal support flooded the economy. Americans began watching prices more closely and worrying about their purchasing power. That worry itself has economic consequences as risk aversion and expectation play vital roles to the future path of inflation.

Take a simple example. A worker gets a 5% raise at the office. Ordinarily, that would feel like progress, however with inflation near 10% during the inflation spike, the raise represented a step backward. That one time loss however can turn into many rounds of expectation forecasts.

Now, even if inflation moderates to 5%, that worker may push for a 10% raise to “make up” lost ground. Multiply that mentality across millions of households and businesses, and suddenly wage pressures and price expectations are stronger than what the actual inflation rate would suggest.

This is the essence of inflation’s “stickiness.” Prices can rise as we saw in 2021 and 2022 but take their time coming down. Once expectations of higher prices seep into consumer psychology, they take longer to fade. The Sticky Price Consumer Price Index Less Food and Energy spiked from 2.3% in August 2021 to its near peak in September 2022, however, three years later the United States remains above 3% inflation clocking in at 3.4% in August 2025. Inflation falls not in a straight line but in a very stick downward resistant manner. That belief, rather than just the hard data, is one factor that keeps the price moderation process slow and uneven.

Evidence of Expectations at Work

The problem of consumer and business expectations plays out in the data. The University of Michigan’s closely watched survey shows short-term inflation expectations stood at 4.5% in July, down from a recent high of 6.6% in May. Though progress, inflation expectations remain well above actual inflation. Core PCE, the Fed’s preferred measure, is running closer to 3.5%. In other words, people still expect prices to rise faster than they currently are. That gap between observed statistical results and expectations matters, because businesses and households base decisions on what they expect to happen, not just what the last data release shows. If households expect prices to rise by 6% even if prices are rising by 3%, they will push for wage hikes of 6% rather than 3%.

At the same time, long-run expectations remain remarkably stable. Five-year inflation expectations are still anchored around 2–2.5%, essentially unchanged despite the turbulence of the past few years. This anchoring is crucial. It suggests that, despite elevated short-term anxieties, most Americans still trust that inflation will eventually return to normal levels. That trust reflects confidence in the Federal Reserve’s commitment and credibility.

The tension between these two views of elevated near-term expectations but stable long-term expectations captures a central challenge of today’s inflation story. Households and firms still feel the bite of higher prices in the short run, and that feeling influences behavior. Yet structurally, the economy has not tipped into an unanchored inflation regime. Consumers continue to believe inflation will return to pre-covid normal of around 2%. That duality explains why inflation proven so slow to fade while also remaining anchored to an expectation of 2% normalcy.

Observing Consumer Expectations

A good proxy for observing consumer sentiment about expectations focuses on long term commitments about interest rates and income expectations: home sales. Existing home sales in the United States remain steady over the past years bouncing between 600-700 thousand per month. This contrasts with the post-covid peak of just over one million. To provide some context here, the current level of new one family homes sold remains similar to 2017. Existing home sales are down by similar amounts roughly one third from the 2020-2022 time frame.

Consumers expect interest rates to fall in the long term and do not want to make long term commitments now or commitments at the implied price level expecting those those monthly debt service prices to fall in the future.

This captures the gordian knot of expectations: consumers behave expecting inflation to remain high and behaving with the expectation inflation will fall. As long as consumers behave in the short term as if inflation will remain high, it pushes off into the future the reality of inflation coming down as expected. Consumers both expect inflation to remain high and come down at the same time. While rational, behaving as though inflation will remain high will continue to keep it high. This circular logic defines the the self fulfilling prophecy of the expectations of inflation.

The Reality of Inflation Expectations

This may seem a current debate over how consumers impact the future path of inflation but it also critiques the historical debate on the forward path of inflation. As inflation spiked, the economic and political debate focused on the supposed transitory nature of the post covid inflation. In reality, a lengthy strand of economic research focuses on the downward stickiness of inflation for a variety of reasons, a lengthy research history that eminent economist should know.

Research on price expectations and downward stickiness cover a variety of areas. For instance, news consumption and how inflation expectations adjust upwards when inflation increase appear in the the news but lack of coverage when inflation declines introduces information asymmetries and slows evolution in expectations. Other research demonstrates user risk and ambiguity aversion meaning they respond very slowly to inflation price signals due to questions about their information quality andrisk aversion about the potential return of inflation.

Despite many eminent politicians and economist arguing for the potential transitory nature of post-covid inflation, the harsh reality from years of research came true. The highest probability event of downward stickiness in prices came true while the political wishes of scientists failed to materialize.

Now at year three post inflation peak after a one year spike in prices, the United States continues to witness prices slowly decline. The highest probability path forward remains a multi-year decline back to what Americans in the first 25 years of the 21st century knew as “normal” interest and inflation rates.

This is part I of a series on the dynamics and future path of inflation in the United States