Stock markets are choppy, and a fog has descended on the economic outlook. That has business leaders and market watchers on the hunt for signs in the economic data to guide them.
However, one of the most important drivers of the economy can’t easily be seen even when skies are clear: anchors. These are rules of thumb that, for better or worse, guide how people make decisions.
These anchors have the power to change the course of inflation and, in turn, monetary policy.
Quick and dirty decision-making
When economists talk about the economy, they typically take a high-level, aggregate view of inflation, job growth, consumer spending, business investment, and other data points.
But behind those numbers are millions of individual decisionmakers like you and me, a group so powerful that it has given rise to an entire subfield of economics known as behavioral economics.
One tenet of behavioral economics is that economists have the time, discipline, and training to build mathematical models and maximize outcomes, but most people don’t. They’re busy working, raising families, and playing pickleball. Instead of relying on models, people use shortcuts. And those shortcuts define the economy.
A useful but flawed rule of thumb
Anchoring is one of the most effective heuristics for making economic choices. It doesn’t always lead to the best decision, but it allows a person to reach a decision quickly that, more often than not, is good enough.
In one example of anchoring, a person uses the first piece of information they have to inform subsequent decisions. For a canonical example, let’s turn to the shopping mall.
A bag that costs $1,200 is, by most accounts, expensive. But a bag that is normally $2,400 and on sale for $1,200 might seem like a bargain if the shopper has anchored their belief that the bag’s value is $2,400, simply because that was the first price they saw.
Anchoring and inflation
Anchoring informs how people view prices and price changes. Unlike economists, Main Street judges inflation not by the economic metrics it sees in the newspaper, but by how much a price deviates from its anchor.
Beliefs anchored to past prices lead to expectations of how quickly prices are rising.
Anchoring plays an important role in the pace of inflation. If consumer price expectations are well anchored at a healthy level for the economy, inflation can be sustained at comfortable rates for decades. That’s because even though prices are always changing, consumer beliefs are anchored on their prior observance of prices. They discount or ignore new information.
But if those anchors come loose, consumers and businesses start expecting prices to rise quickly, and their behavior might bring about the very inflation they expect.
For example, businesses that anticipate a cost increase on inputs might raise prices on their products to cover those impending increases. Households might front-load their spending to stock up on goods and services they believe will cost more later. These behaviors lead to a surge in prices that can trigger higher inflation.
Inflation expectations are notoriously difficult to measure. In February 2020, just before the pandemic, consumers expected inflation to grow at a moderate annualized rate of 2.5 percent, according to the Federal Reserve Bank of New York’s monthly consumer survey. But as pandemic-induced inflation soared, inflation expectations jumped to a high of 6.8 percent in June 2022. As inflation slowed, inflation expectations moderated, dropping to 2.9 percent in October 2024.
Importantly, expectations have yet to return to 2.5 percent. In fact, they’ve edged upward, to 3.1 percent in February.
The University of Michigan measure of consumer sentiment also has shown an increase in inflation expectations.
My take
Main Street shoppers and businesses typically don’t pay close attention to inflation statistics. They set expectations about the cost of eggs, haircuts, or airline tickets based on their price anchors.
Before the pandemic, these expectations were anchored at a rate that neither overheated nor cooled economic growth. That allowed the world’s central banks to keep interest rates at rock bottom, boosting economic growth.
Monetary policy aided by well-anchored consumers now could shift as inflation expectations rise even though the pace of actual inflation is slowing.
Why, if inflation is coming down, do people expect it to rise?
Inflation expectations historically tended to bounce around in a narrow range but usually anchored back at their economic sweet spot, close to the Fed’s 2 percent target rate. It’s easier for inflation expectations to come unset now because instead of 40 years of low and steady inflation before the pandemic, consumers recently have experienced abnormally high and irregular inflation. As a result, Main Street’s beliefs about inflation could be shifting higher. That, my friends, is the power of anchoring, the quick and dirty decision-making tricks we all use that work really well—until they don’t.
The week ahead
Monday: The S&P Global Flash PMI surveys provide a quick take on manufacturing and service sector activity. Services bounced back stronger than economists expected after faltering last month, while manufacturing fell and signaled future weakness in the sector.
Tuesday: Home prices are a natural place to anchor expectations of inflation. We’ll get a read on January prices from the S&P CoreLogic Case-Shiller Home Price Index and February new home sales from the Census Bureau. I want to know whether a slight decline in mortgage rates have boosted homebuyer demand.
Wednesday: Demand for durable goods, as measured by the Census Bureau will tell us whether consumers are still showing interest in big-ticket items such as refrigerators and furniture.
Thursday: A complementary statistic to durable goods, inventory data from Census will provide a good indication of how retailers are interpreting consumer demand.
Friday: The week’s big headline number is the Personal Consumption Expenditures Price Index, the Fed’s favorite measure of inflation. Last week the Fed rate decisionmakers raised their collective projection for PCE inflation to 2.7 percent from 2.5 percent when they met in December.
