The central bankers around the world may be attempting the impossible: to get into the psyche of business executives, labor unions and ordinary households in real time to try to understand how they are navigating their finances through what appears to be yet another major energy shock.
Policymakers are contemplating whether to jack up interest rates to combat rising inflation. But they will only pull the trigger if they think a surge in energy costs induced by the Iran war will filter into other prices, lifting inflation expectations across the entire economy.
The problem is that measuring such expectations is notoriously difficult. Central banks have a trove of surveys, gauges and indicators at their disposal, but all of them have blind spots if not outright faults.
Since the COVID-19 pandemic, they have developed new tools to fill gaps in data about behavior. But measuring expectations remains more of an art than an exact science.
That could raise the bar for rate hikes as policymakers are wary of gut-feeling decisions and usually prefer to wait for more evidence to narrow the risk of a policy error.
Policy-makers at the Bank of Canada acknowledged that global uncertainty meant they "would need to rely on judgment more heavily than usual" to plot the path of the economy, according to minutes of its March 18 meeting at which it kept rates on hold.
Others describe the effort involved in the process.
"I try hard to get into the thoughts of price-setters and how they are seeing it – trying to calibrate their confidence in pricing power," Richmond Federal Reserve Bank President Tom Barkin told Reuters.
"The 'hike' case would be around inflation expectations starting to finally move," he said. "I don't have a sense that they've broken out at this point."
One complication is that behaviors change.
In 2022, consumers and firms had little experience with rapid inflation, making price- and wage-setting a rather rigid exercise.
"But now people have lived through a painful episode of inflation, and this may mean that inflation expectations are more fragile, and so they could be more sensitive to such an energy price shock," European Central Bank (ECB) board member Isabel Schnabel said in a university lecture on Friday.
For companies, changing their selling prices was a cumbersome process before the pandemic and so they limited adjustments, often to once a year. This became untenable and the frequency of changes skyrocketed, Schnabel argued.
This makes the frequency and not just the magnitude of such changes a good indicator that expectations are shifting.
Traditionally, central banks relied on surveys and market indicators to assess expectations. But surveys are not done frequently enough to capture rapid changes and their time horizon is often out of sync with that of policymakers.
Market indicators of expected inflation are also imperfect because they include the extra return, or risk premium, that investors demand for holding a particular financial instrument. This changes with market sentiment, blurring shifts in actual price expectations.
The stakes are high: investors now expect the ECB to raise rates two or three times this year, the Bank of England (BoE) twice, and have given up on any Fed rate cuts in 2026.
To compensate for such information gaps, central banks have developed an array of new tools. They track expected wage changes, including via major pay deals announced by unions, which may be a signal to others negotiating their own pay.
They survey firms directly and speak to executives to gauge expected behavior, and they take on board ever-larger numbers of external surveys with forward-looking indicators.
Central bank staff track the frequency of price changes, correct existing surveys to fill data gaps and have revised their own projection models to address shortcomings that missed 2022's inflation surge caused by the pandemic and Ukraine war.
Also key to their judgment call is trying to understand how this inflation shock differs from four years ago.
The consensus on this seems firm: conditions are fundamentally different.
Interest rates are already higher, government purses are tighter, there is growing slack in the labor market, and - unlike during the pandemic, when they were unable to spend - households are not sitting on piles of cash.
"We’re coming into this situation with the gradual disinflation that we were having, the labor market is softening (and) growth is a little bit below potential," Bank of England Governor Andrew Bailey told Reuters.
"And one of the consistent messages we get from businesses is, for most sectors of the economy, a real lack of pricing power."
Using their enhanced insight, central banks are, for now, confident that longer-term inflation expectations are holding firm around their targets.
But the longer the war drags on, the longer energy prices will stay high, and as consumers see everyday costs like fueling their cars rise, the more likely it is that inflation expectations will move upwards. When exactly this happens will not be clear, leaving policymakers to judge for themselves.
"Economics itself is not an exact science," ECB policymaker Primoz Dolenc said.
"It's of course based on analytics, but by definition, there is also a perception and judgment element."
