Fed's faith in anchored inflation expectations may be coming under stress

By Howard Schneider

WASHINGTON, March 30 (Reuters) - Federal Reserve officials eager to keep inflation psychology in check and maintain control over prices face a challenge as household expectations rise alongside the cost of gasoline and doubt edges into bond markets in the form of rising yields on U.S. Treasury securities.

Until the U.S.-Israeli war with Iran pushed the price of oil up more than 50% over four weeks, U.S. central bankers were largely comfortable that public inflation expectations, particularly those regarding the longer-term outlook for prices, were "anchored" and consistent with the Fed's 2% inflation target - evidence of faith in their commitment and ability to meet their inflation goal.

But with rising gasoline prices hitting consumers almost daily, airfare and other increases likely not far behind, and global oil prices lodged around $110 a barrel, the Fed is paying close attention to any evidence of drift in the various surveys and investments that are felt to reflect views about future inflation.

"Long-term inflation expectations are consistent with 2%, but they may also be a little more fragile," after several years of above-target inflation and now another potential price shock developing, Philadelphia Fed President Anna Paulson said on Friday at a San Francisco Fed conference.

Weak U.S. Treasury auctions last week, with high yields partly attributed to investors' inflation concerns, were followed on Friday by a University of Michigan survey showing a jump in household price expectations over a one-year period.

"That is on everyone's mind," Fed Chair Jerome Powell said during a press conference on March 18 that was dominated by questions about how the central bank assessed the economic risks of the war with Iran, and in particular whether another price shock, coming after a five-year run in which it has missed its inflation target, could be the one that causes the public to lose faith.

As oil prices have risen, investors have priced out any expectation of Fed interest rate cuts for now, and have been betting more heavily on the possibility of a hike in rates this year. Even hinting at it - as some central bank officials have begun doing - can shift the market outlook and help bolster the central bank's case that it is serious about inflation.

It is a hard-learned lesson and one that policymakers have pledged not to forget. Inflationary psychology in the 1970s is thought to have led firms and households to aggressively bid up wages and prices in the absence of a firm central bank commitment, a dynamic that was only changed through punishing rate hikes that caused a sharp recession in the early 1980s.

"I don't think we are going to let it color our decision-making more than is appropriate," Powell said of the lessons from five decades ago. But "it has been five years. We had the tariff shock. We had the pandemic. Now we have an energy shock of some size and duration. ... It's a repeated set of things, and you worry that's the kind of thing that can cause trouble for inflation expectations. We worry a lot about that. We are very strongly committed to doing what it takes to keep inflation expectations anchored at 2%."

EXPECTATIONS AT 'THE CORE' OF CENTRAL BANKING

The current situation is a recipe for a more hawkish monetary policy approach, even though there's no agreed way to measure what Powell says the Fed is trying to achieve. In an institution that spars over how to interpret even basic data like the unemployment rate, abstract concepts such as "expectations" become a sort of dealer's-choice exercise - with different policymakers putting weight on different financial market or survey measures of how public views of inflation may be changing.

"Expectations are at the core of central bank policymaking," with credible promises to keep inflation controlled seen as key to a central bank's effectiveness, said Ed Al-Hussainy, a fixed income and macro portfolio manager at Columbia Threadneedle.

Yet expectations are impossible to measure directly and open to interpretation.

Officials want "to make sure that people believe they'll do whatever it takes to keep inflation down," Al-Hussainy said. "But if you articulate what those expectations are, I think you lose a little bit of kind of the strategic ambiguity ... You lose a little bit of that flexibility to make policy on a discretionary basis."

Debate over what metrics matter could intensify in the coming weeks.

Some of the Fed's go-to measures of expectations, including one derived from the prices of securities that reflect what inflation will be on average for the five-year period beginning five years from now, have stayed reasonably close to 2% even during the breakout of inflation during the COVID-19 pandemic.

Yet there are some less settled signs, and Fed policymakers have taken notice. Along with the expected rise in consumer inflation expectations last week - something central bank officials have tended to discount as volatile and overly influenced by gas prices - the weak results of U.S. Treasury auctions were seen by investors as reflecting increasing worry about U.S. inflation.

Other long-running surveys, like the New York Fed's monthly poll of consumers, are also seen as showing "anchored" expectations - and, in fact, ticked down in the short run in the most recent report.

But that data was for February, before what has now been a month of high and rising oil prices, volatility in stock and bond markets, and no clear endgame for a conflict that consumers are feeling at the gas pump and eventually will in other areas of their spending.

"We have had five years now of inflation at elevated levels, and near-term inflation expectations have risen again, so I am particularly concerned that yet another price shock could increase longer-term inflation expectations," Fed Governor Michael Barr said on Thursday at a Brookings Institution event in Washington. "We need to be especially vigilant."

(Reporting by Howard Schneider;Editing by Dan Burns and Paul Simao)