The Federal Reserve (Fed) has painted a picture of a US economy in which businesses are increasingly concerned about rising input costs and are planning to pass those costs on to consumers. As of June 2025, households seem to be bracing for a return to higher prices. All three major consumer surveys — University of Michigan, New York Fed and Conference Board — put expected inflation over the next year at more than 3%, with two even higher. According to the University of Michigan, these inflation fears are widespread across age and income groups. These shifts in sentiment underscore a core challenge for the Fed: how to manage inflation expectations amid lingering public unease.

The Fed’s tightrope

It is tempting to dismiss consumer expectations as noisy or unreliable. Fed Governor Christopher Waller recently remarked, “I tend to discount survey-based measures of inflation … since investors have more skin in the game than survey respondents,” highlighting his preference for market-based signals like breakeven inflation rates, which he views as more grounded in economic incentives and real-time information.

Historically, consumers tend to overestimate inflation, but this doesn’t negate the economic importance of their views. Consumer and business expectations shape wage bargaining, consumption patterns and price-setting behavior. In that sense, they can become self-fulfilling.

Anchored long-term inflation expectations, which remain stable in the face of temporary shocks to inflation, are a cornerstone of the Fed’s credibility and its ability to effectively manage monetary policy. In March, Fed Governor Adriana Kugler expressed concern over the recent rise in five-year inflation expectations, which reached 3.9% according to the University of Michigan’s survey. She highlighted that such elevated expectations could complicate the Fed’s efforts to maintain price stability and underscored the importance of preventing inflation expectations from becoming unanchored.

Similarly, Minneapolis Fed President Neel Kashkari reinforced this view by stating that anchoring inflation expectations is “paramount” for the success of monetary policy. Both officials emphasized that stable, well-anchored expectations allow the Fed to respond flexibly to economic changes without fueling further inflation or triggering unnecessary market volatility.

Historical context

Historically, consumers have expected more inflation than has actually materialized. Market-based measures like Treasury Inflation-Protected Securities (TIPS) breakevens or the Survey of Professional Forecasters tend to offer more accurate inflation predictions. But during the 2021–2022 inflation shock, consumers were surprisingly prescient. While central bankers and markets underestimated the magnitude and persistence of price increases, consumer expectations were more aligned with the actual inflation trajectory.

This rare alignment between consumer expectations and realized inflation has had significant psychological and policy consequences. After a decade of subdued inflation, the rapid price increases during this episode left a lasting mark on household sentiment. For many consumers, the experience of visibly higher prices for essentials like food, gasoline and rent reinforced a belief that inflation was persistent.

Even as inflation metrics have cooled, these expectations have remained elevated. The episode re-anchored inflation perceptions at a higher level, demonstrating that consumer expectations, while often dismissed, can be shaped by salient price shocks and may carry enduring influence in the broader inflation narrative.

This insight brings us to another source of confusion and tension: how inflation is measured, and why that often diverges from how it is felt.

Headline inflation vs. technical inflation

Despite grocery prices rising less than 2% over the past year and price increases slowing since mid-2022, consumers in 2025 still cite groceries as their top economic concern. This disconnect is clearer when noting that grocery prices have increased over 27% in the past five years. While inflation measures the rate of price change over time, consumers often feel the cumulative burden of higher prices without focusing on specific periods. Unlike economists who differentiate between inflation rates and price levels, consumers perceive persistently higher price levels as ongoing economic pressure.

This distinction between headline inflation and consumer experience is more than a technical nuance — it shapes how the public perceives inflation and forms expectations. Consumers focus on the prices of everyday essentials, even though these items may have relatively small weights in core inflation metrics that exclude volatile components. For instance, the recent spike in egg prices caused by avian flu garnered widespread attention, despite eggs accounting for less than 0.2% of the typical consumer basket. Such noticeable price jumps can heavily influence consumer inflation perceptions, even when headline inflation remains stable or low.

Meanwhile, inflation measures favored by policymakers are often complex and less transparent to the general public. These include core inflation, which tracks how prices are rising while excluding the unpredictable food and energy; trimmed-mean consumer price index (CPI), a measure of core inflation that excludes components with the most extreme price changes in a given period; and the personal consumption expenditure (PCE) deflator, a measure of inflation that reflects the price changes of goods and services purchased by buyers in the United States. These measures smooth out fluctuations by excluding volatile categories to highlight underlying inflation trends. However, this approach can create a disconnect between what economists consider “transitory” price changes and the persistently higher price levels consumers feel daily. This gap complicates communication efforts and poses a challenge for the Fed, as it must bridge the divide between technical inflation data and public perceptions to effectively shape inflation expectations.

The inflation perception gap

While year-over-year inflation rates have moderated, the cumulative increase in prices since the onset of the Covid-19 pandemic remains substantial — creating a persistent gap between technical measures of disinflation and the public’s lived experience. For instance, grocery prices may have risen only 2% over the past year, but they are still over 27% higher than five years ago. For households, this cumulative burden shapes perceptions of inflation more powerfully than monthly data releases or core inflation indices. This helps explain why consumer inflation expectations remain elevated, even as headline inflation decelerates.

The Federal Reserve Bank of New York’s May 2025 Survey of Consumer Expectations reflects tentative progress: Median inflation expectations declined across the one-, three- and five-year horizons — to 3.2%, 3% and 2.6%, respectively — and the range of disagreement among respondents also narrowed. These developments suggest early signs of re-anchoring.

However, they should be interpreted with caution. Statistical improvement in expectations may not fully capture the enduring psychological impact of accumulated price increases. In this sense, inflation expectations are not only backward-looking or forward-looking — they are experience-based. Until the cumulative effects of high prices are addressed or better communicated, the disconnect between macroeconomic data and consumer sentiment will likely continue, complicating the Fed’s efforts to stabilize expectations through traditional policy channels.

Recognizing this gap is only the first step. Addressing it requires recalibration of not just tools, but also the Fed’s messaging and its understanding of public inflation psychology.

How can the Fed influence inflation expectations?

The Fed influences inflation expectations through a combination of traditional policy tools and forward-looking communication strategies, with the ultimate goal of maintaining price stability. One conventional method is adjusting short-term interest rates to help bring inflation closer to the Fed’s long-run target of 2%. However, when interest rates are near zero — as they were following the Global Financial Crisis and again during the Covid-19 pandemic — the Fed increasingly turns to forward guidance. This involves clearly communicating the likely future course of monetary policy to shape public beliefs and economic decisions today. Over time, this approach has become a crucial component of the Fed’s policy toolkit.

The focus on managing expectations is grounded in decades of economic theory. In the late 1960s, economists Milton Friedman and Edmund Phelps argued that inflation expectations were central to the inflation-unemployment tradeoff. Their insights laid the groundwork for what would become the rational expectations revolution, further advanced by Lucas and Sargent in 1972 and 1973, respectively. These economists showed that when economic agents anticipate future policy actions, unanticipated monetary moves lose effectiveness, shifting emphasis to policy credibility and transparency. In this view, influencing expectations is not just a communication task but a core mechanism of how modern monetary policy affects real outcomes like wages, prices and employment.

Reflecting this understanding, the Fed adopted a new policy framework in August 2020 called Flexible Average Inflation Targeting (FAIT). While keeping its 2% inflation target intact, the Fed announced that it would allow inflation to temporarily overshoot 2% following periods of underperformance, to make up for earlier shortfalls. Under the previous regime, the Fed simply tried to return inflation to target without compensating for missed periods. FAIT, by contrast, aimed to re-anchor inflation expectations by committing to a more symmetrical and flexible response: encouraging inflation above 2% when necessary but not forcing it below 2% to counteract overshoots. This shift signaled a stronger commitment to long-term price stability and acknowledged the real-world limitations of past frameworks, especially in an era of persistently low inflation.

Policy implications

The widening gap between consumer and market-based inflation expectations reveals a deeper structural tension in today’s macroeconomic landscape, one that sits at the intersection of lived economic experience and technocratic abstraction. For households, inflation is not a number — it is a felt reality shaped by rising grocery bills, rent increases and medical expenses. These cumulative costs are embedded in memory and daily life. By contrast, markets and professional forecasters focus on marginal changes, statistical smoothing and forward-looking indicators that may fail to capture the emotional and social imprint of past inflation shocks.

This disconnect is not merely academic. It has direct consequences for monetary policy transmission. Inflation expectations — especially those held by consumers and businesses — are foundational to wage bargaining, pricing behavior and consumption decisions. When these expectations become unanchored or diverge from the Fed’s target, they can either erode the effectiveness of rate hikes or delay the benefits of easing.

Importantly, expectations are not static predictions — they are shaped by narratives, trust and communication. The Fed has long understood this, using forward guidance, transparency initiatives and public messaging policy as tools. Yet today’s landscape demands more than precision in data or elegance in models. It requires the Fed to build and maintain a shared understanding with the public — economic storytelling that can bridge the expectations gap.

To succeed, the Fed must walk a narrow path. It must reaffirm its inflation-fighting credibility without triggering public panic or undermining economic recovery. It must explain the difference between inflation levels and rates, between core and headline measures and between technical volatility and structural risk. And crucially, it must do so while recognizing the legitimacy of consumer concerns rather than dismissing them as noise.

If the Fed can anchor expectations across both Main Street and Wall Street — tempering fears, reinforcing trust and providing policy clarity — it will reestablish control over inflation dynamics and restore confidence in the broader framework of monetary governance. That outcome is not just a technical success. It is a prerequisite for economic resilience in a world of rising uncertainty.

[Lee Thompson-Kolar edited this piece.]

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.