[Opinion] Expectations Are a Key Force Driving the Economy

To Curb Interest Rate Hikes,
Expected Inflation Must Be Reduced
Market Predicts Early End to US Tightening

On July 27, the United States took another 'giant step' (a 0.75% point increase in the benchmark interest rate). Reporters persistently questioned Jerome Powell, Chair of the Federal Reserve (Fed), about the possibility of a U.S. economic recession. Powell denied the recession by citing a strong labor market but remained silent on future possibilities. While he did not rule out another giant step in September, perhaps deep down he preferred to believe that inflation control would succeed. He might be considering a big step (a 0.50% point increase) rather than a giant step.

The International Monetary Fund (IMF) downgraded its global growth forecast and warned of recession risks due to high inflation. It lowered the global growth outlook for this year (3.6% → 3.2%) and next year (3.6% → 2.9%). The main reasons were ongoing risk factors such as inflation shocks from the Russia-Ukraine war, prolonged supply disruptions caused by the COVID-19 pandemic, tightening financial conditions, and central banks’ efforts to curb inflation. While recession prospects increased, inflation forecasts were revised upward. The IMF raised inflation forecasts for advanced and emerging economies this year (5.7% → 6.6%, 8.7% → 9.5%). It anticipated that inflation could persist at higher levels for longer than expected.

High inflationary pressure undermines macroeconomic stability. On June 28, the Bank of Korea projected in a report that rising U.S. inflation expectations would exert significant upward pressure on South Korea’s medium- and short-term government bond yields. Since domestic inflation expectations are synchronized with those in the U.S., the report emphasized the importance of managing inflation expectations. Economics has long recognized that expectations are directly reflected in prices; this was already understood in the 1920s. At that time, American economist Irving Fisher argued that the nominal interest rate equals the sum of the real interest rate and expected inflation. This is known as the Fisher effect. To suppress rising interest rates, monetary authorities must reduce expected inflation.

Expectations are formed based on various information and experiences. According to a survey conducted by investment bank Morgan Stanley from July 15 to 18 involving about 2,000 Americans, two-thirds of respondents said they would reduce spending over the next six months due to inflation. As people adjust their expectations, they have begun to change their behavior unusually to save money. The U.S. composite Purchasing Managers’ Index (PMI), which combines goods and services, fell to 47.5, the lowest since May 2020. The PMI dropped below 50 for the first time in over two years, signaling contraction and evoking fears of a recession. Many complain that reports from international organizations or central banks are delayed and lag behind the market.

With personal consumption expenditure (PCE) inflation still at its peak in June, uncertainty remains about when inflation will slow. While the short term is unclear, let’s look at another indicator showing investors’ expected inflation. The 5-year forward breakeven inflation rate (forward BEI) has fallen below the level just before Russia’s invasion of Ukraine. This means the market expects the Fed’s tightening stance to end sooner and at a lower level than previously thought. The bond market, anticipating a U.S. benchmark interest rate of 3.5% by year-end, may be reflecting expectations of a U.S. recession. If one is weighing the timing of a rate cut, is it like looking for water in a dry well? U.S. stock prices rose sharply in July.

Jo Won-kyung, Professor at UNIST / Director of the Global Industry Cooperation Center