Yesterday, when I had a lunch meeting with the chief scientist at Fannie Mae, our conversation quickly turned to inflation.

My view of that is more pessimistic than the Fed and most mainline economists. Somehow, these economists seem to have forgotten a basic economic tenet – the rational expectation theory. This theory, to put it in layman’s terms, basically says that on aggregate, what people expect to happen will happen. That’s why Fed officials have long been extremely careful about what they say that could change people’s expectations. 

Today’s Fed under Jerome Powell has been much less careful. Here are the three acts of the current Fed that have crushed the expectation that inflation will stay low and stable. 

1. In March of 2020, at the onset of the pandemic, the Fed announced “unlimited” asset purchases. To put it simply, this means “unlimited” money printing to support the market. 
2. The Fed also announced that they would not limit their asset purchases to Treasury and Agency debts that have explicit or implicit guarantees of the US. They would purchase municipal debts and corporate debts as well. This created more avenues for the Fed to create money, but it’s a slippery slope. If the full faith and credit of the US is not essential to the Fed’s balance sheet, what about my personal lending? I lent $1000 to a friend, and got an IOU in return. Will the Fed also purchase my IOU? Now I say this as a joke, but the fact that such a joke can be told just shows how the expectation has changed. 
3. Later, the Fed also announced a new definition of their 2% inflation “target” – they don’t mind letting inflation go above 2%, as long as the long-term average is 2%. In the past, they have tried to keep it under 2%, period.

These are all announcements that change expectations. They sent an important signal to the market: inflation be damned, the Fed will print money. 

Once people expect inflation, it takes on a life of its own: inflation begets more inflation. Businesses feel freer to raise prices, employees feel freer to ask for wage hikes. The Fed may stop quantitative easing, and raise interest rates. They hope that doing these things will be enough to rein in inflation.  But the Fed can not un-say what has already been said. Doing all of those things will not be enough to change people’s expectation that this Fed is an easy money Fed. It might take a change of Fed chairman, with the new chairman pulling a Paul Volcker to change people’s expectations. 

My Fannie Mae chief scientist friend concurred.

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