The latest University of Michigan Consumer Sentiment Survey delivers a stark warning about U.S. monetary stability.
Following Trump’s return to the presidency in the November 2024 election, inflation expectations have surged dramatically.
The short-term (one-year) inflation expectations have jumped to 4.3% – a level that should set alarm bells ringing.
Even more concerning is the steady drift upward in long-term (5-year) expectations, which have continued to creep higher even as actual inflation moderated through 2023-24.
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To put this shift in perspective, we’ve only seen similarly dramatic surges in inflation expectations twice before in the survey’s history since 1978: following the 9/11 terrorist attacks in 2002 and during the late 1970s. The current surge suggests a fundamental shift in public confidence about future price stability – and the historical parallels are deeply troubling.
The Velocity Warning Signal
To understand why this surge in inflation expectations is so concerning, we need to look back at a crucial lesson from the late 1970s about how quickly monetary policy credibility can unravel.
The most telling indicator of monetary policy credibility is often found in the velocity of money – how quickly people choose to spend rather than hold money balances.
A particularly illuminating graph shows the percentage change in M2 velocity from December 1977, marking two crucial events: Miller’s announcement as Fed Chairman (December 1977) and the Iranian Revolution (February 1979).
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What the data reveals is striking and crucial for understanding our current risks: The dramatic acceleration in velocity began immediately after Miller’s appointment was announced, well before the Iranian Revolution.
From a slightly negative trend in late 1977, velocity jumped by nearly 4% within months of Miller’s appointment and continued to accelerate steadily. By the time the Iranian Revolution hit in early 1979, velocity was already up by 7% from its pre-Miller level.
The Political Erosion of Fed Credibility
This timing is crucial – it wasn’t external shocks that initially triggered the velocity surge, but rather the market’s immediate reaction to the politicisation of the Federal Reserve.
When President Jimmy Carter chose G. William Miller, the CEO of Textron, to replace Arthur Burns in December 1977, it was widely seen as a political choice – Carter wanted someone who would prioritize his administration’s focus on employment over inflation fighting. Miller, lacking strong monetary policy convictions, was expected to be more amenable to the White House’s preferences than Arthur Burns.
The market’s response was swift and clear. The acceleration in velocity shows that Americans began reducing their money holdings almost immediately after Miller’s appointment was announced, well before he even took office in March 1978. This wasn’t a gradual loss of confidence – it was an immediate reaction to the perceived politicisation of monetary policy.
By the time the Iranian Revolution added its own inflationary pressures in 1979, the foundational damage to Fed credibility was already done.
The velocity surge continued and intensified, with the cumulative increase in velocity between 1977 and 1982 contributing to a 12% rise in the U.S. price level – a massive inflationary impulse that ultimately required Paul Volcker’s dramatic interest rate hikes to contain.
The Trump-Powell Dynamic
This historical episode holds urgent lessons for today. Trump has already demonstrated his willingness to publicly attack Fed independence, famously comparing Jerome Powell to China as an “enemy” during his first term.
Now, with his return to office secured and his promise to “bring down prices,” there are growing concerns that he will attempt to replace Powell with a more politically compliant Fed chair – essentially recreating the Miller scenario.
The risk is particularly acute because Trump has explicitly linked his anti-inflation promises with criticism of Fed independence. The market reaction to any move against Powell could be similar to what we saw with Miller – an immediate jump in velocity as people lose confidence in monetary policy independence.
The Compounding Risk of Trade Restrictions
Adding to these concerns is Trump’s proposed expansion of tariffs and trade restrictions. While these would be inflationary in their own right, the real danger lies in their combination with any erosion of Fed independence. Just as the Iranian Revolution’s inflationary impact was magnified by Miller’s compromised monetary policy, Trump’s trade restrictions would be far more damaging in an environment of questioned Fed credibility.
The Expectations-Velocity Nexus
The connection between inflation expectations and velocity is straightforward but powerful: When people expect higher inflation, they reduce their money holdings and spend more quickly, effectively increasing the velocity of money. Unless the Federal Reserve responds by reducing money supply growth, this acceleration in velocity translates directly into higher inflation – potentially creating a self-fulfilling prophecy.
The current surge in inflation expectations we’re seeing in the Michigan Survey could be the precursor to a similar velocity spike. Just as in 1977-78, markets appear to be pricing in the risk of political interference with monetary policy before any actual changes have occurred.
Looking Forward
The velocity data from 1977-79 serves as a stark warning: the markets don’t wait for actual policy mistakes when monetary policy independence is threatened – they react to the threat itself.
The immediate jump in velocity following Miller’s appointment shows how quickly confidence can erode when markets perceive political interference with monetary policy.
The current surge in inflation expectations might reflect similar fears – not just about Trump’s specific policies, but about the future independence of the Federal Reserve itself. The lesson from 1977 is clear: once the public believes monetary policy has been politicised, the impact on money demand is immediate, and the cost of restoring credibility becomes enormously high.
The combination of rising inflation expectations, threats to Fed independence, and proposed trade restrictions creates a risk scenario remarkably similar to the late 1970s.
The irony is that Trump’s anti-inflation rhetoric, combined with policies that undermine Fed credibility and create supply-side price pressures through trade restrictions, might create exactly the kind of inflation surge he claims to oppose.