The Federal Reserve's worst-case scenario is unfolding in real time. After nearly achieving its 2% inflation target just a year ago, the central bank now confronts something far more dangerous than high prices: consumers who no longer believe inflation will come down.
The University of Michigan's latest consumer sentiment survey shows long-run inflation expectations jumped to 3.9% in May, up from 3.5% in April and well above the 2.8%-3.2% range that held throughout 2024. Year-ahead expectations rose to 4.8%, exceeding even the 3.4% reading from February before the Iran conflict escalated.
This is what economists call "unanchored expectations"—the point where consumers assume high inflation is the new normal and adjust their behavior accordingly. They demand higher wages. They accelerate purchases before prices rise further. They lose faith in the Fed's ability to control prices. It becomes a self-fulfilling prophecy.
Chris Waller, a Federal Reserve Governor, laid out the danger in a speech in Germany last week: "If people do not know the true inflation generating process and see a sequence of positive price shocks, they may infer that the next price shock is more likely to be positive than negative."
Translation: Once consumers stop trusting the Fed's 2% target, every price increase reinforces their pessimism. The central bank loses credibility, and with it, the ability to control inflation without causing severe economic pain.
The political dimension adds another layer of complexity. Even Donald Trump's supporters—who helped return him to the White House partly on promises to bring down prices—now doubt relief is coming. Republicans' long-term inflation expectations more than doubled since February 2025, according to the Michigan survey.
Consumer sentiment has fallen below levels seen during the 1970s oil crises, dropping to record lows for three consecutive months. Joanne Hsu of the University of Michigan notes that "consumers appear worried that inflation will increase and proliferate beyond fuel prices, even in the long run."
The numbers don't lie, but executives sometimes do. The Fed spent months insisting inflation was "transitory" in 2021, only to reverse course and deliver the most aggressive rate hiking campaign in four decades. That credibility wound still hasn't healed.
Now Chair Jerome Powell faces an impossible choice. Hold rates steady and risk letting inflation expectations spiral further out of control. Or raise rates again into a slowing economy, potentially triggering the recession the Fed has worked so hard to avoid.
Energy prices from the Iran situation aren't helping. But the deeper problem is psychological. When consumers lose faith in the Fed's 2% target, that target becomes meaningless. The central bank can't simply declare victory through better communication—it has to earn back trust through results.
The question is whether Powell has the stomach for what that will require. History suggests that once inflation expectations become unanchored, only a sustained period of restrictive policy—and likely some economic pain—can reset them. The Fed may have celebrated too early when inflation briefly approached 2% last spring.
Cui bono? Not consumers watching their purchasing power erode. Not the Fed, now facing a crisis of credibility. And certainly not an administration that promised relief but can't deliver it as global oil markets remain volatile.
The central bank's inflation fight isn't over. In fact, it may be entering its most dangerous phase.
