UBS Chief Economist Paul Donovan has suggested that central banks should prioritize financial market inflation expectations over consumer and corporate surveys when setting monetary policy. Donovan's comments come amid rising oil prices and strong U.S. inflation data.
Brent crude futures, the global oil benchmark, have surged over 71% year-to-date following a joint U.S. and Israel assault on Iran in February. The U.S. Consumer Price Index (CPI) rose 3.4% year-over-year in August, while the Producer Price Index (PPI) increased 5.4% year-over-year. The personal consumption expenditures (PCE) price index has remained above the Federal Reserve's 2% long-term inflation target for 65 straight months.
Wall Street expectations have shifted toward a 25 basis point rate hike by the Federal Open Market Committee (FOMC), driven by the recent CPI and PPI reports. Year-ahead inflation expectations, as measured by the University of Michigan Consumer Sentiment Index, jumped to 4.6% in September, the highest reading since June.
Donovan argues that inflation expectations are only meaningful if they cause a change in economic behavior. He suggests that central bankers should focus specifically on financial market expectations when setting policy, as investors are the most likely to have the power to act and influence the economy.
"Inflation expectations are, themselves, meaningless. Expectations only matter if they cause a change in economic behavior," Donovan stated. "Overemphasizing inflation expectations may lead to policy error."
Donovan's comments highlight the growing importance of financial market expectations in central bank decision-making, particularly in the context of rising oil prices and strong inflation data.
