Fed Warning: Inflation Expectations Spark Rate Hike Fears and Economic Uncertainty

The Federal Reserve has issued an 11-word warning to Wall Street that investors should pay attention to now. According to minutes from its last meeting, years of above-target inflation could begin to affect inflation expectations and wage- and price-setting decisions.

This is a concern because the Fed's 2% inflation target works only when people believe in it. When they stop believing, inflation starts feeding itself - workers push for raises to stay ahead of prices, and businesses raise prices to cover bigger paychecks.

The threat that the public may be starting to adjust their expectations is real, with several years of inflation well above 2% and a recent drop in June's reading from 4.2% to 3.5%. Many businesses have told the Fed they're under real pressure and are weighing how much of rising costs to pass along to customers.

The history of wage-price spirals is a cautionary tale, particularly the one in the 1970s when the public assumed prices would keep climbing and set wages and prices accordingly. The Volcker Fed pushed the federal funds rate to 20% in 1981, causing a recession as unemployment climbed to 10.8%, but it worked - inflation fell from more than 14% in 1980 to 3.5% a few years later.

The current economy is wired for cheap debt, with a substantial amount of it propping up the AI build-out. Data centers are being financed with the expectation of refinancing at better rates that may not come, and much of that money flows through private credit - loans made by investment funds rather than banks.