Chapter 04 of 13

Suspect 4: "Inflation expectations became unanchored"

This is the Seðlabanki's own theory, and the justification for every rate hike from 0.75% to 9.25% and back up again. The story is familiar: when expectations are "well anchored," inflation behaves; when they "become unanchored," inflation runs hot even after the original shock has passed, because households and firms bake the pessimism into wages and prices. The rate tool acts on this by restoring credibility. Believe the central bank will do whatever it takes, the expectation re-anchors, the trend returns to target.

Ask anyone you know — an electrician, a teacher, a shop owner, a web developer — whether they successfully negotiated a wage increase ahead of inflation because they expected next year's CPI to run hot. Almost no one can tell you a story like that. Wages are sticky and backward-looking. You get a raise in December because you suffered through inflation all year, not because your union priced in a forecast. Now ask a merchant why they raised a price. They will tell you their supplier raised theirs — diesel wholesale is up, eggs cost more at the farm gate, the shipping agent sent a new tariff sheet. She is not reading the nation's psychology. She is reading her supplier's invoice. Neither behavior — the backward-looking wage, the replacement-cost markup — is "expectations" in the sense the central bank's models require. Both are mechanical, observable, and tied to realized costs.

Modern central banks run New Keynesian DSGE models, and inside those models inflation persistence is generated by a term representing the expected value of next period's inflation. Take that term out and the math collapses back to target on its own. The problem is that the term was inserted for mathematical tractability, not because anyone ever pinned down its counterpart in the real world. The survey measures cited as evidence expectations have "deanchored" are overwhelmingly adaptive: ask households and firms what they expect inflation to be, and they tell you what it has been recently. Survey expectations are a lagged mirror of realized CPI dressed up in the grammar of forecasting. Jeremy Rudd — a mainstream Federal Reserve economist, not a heterodox critic — walked through the empirical literature in a 2021 working paper and concluded that the belief that expectations drive inflation is theoretically shaky and empirically weak. The paper caused a small scandal inside the Fed because it said out loud what many economists already suspected.

The story central banks tell anyway goes: estimate a model with an expectations term, find that the term is large, conclude that expectations are the cause. But the term is whatever the model needs it to be. It soaks up every bit of persistence the model cannot otherwise explain — supply-chain unwinding, sectoral bottlenecks, contractual indexation, corporate markup behavior — and relabels the residual "psychology."

If the theory is this weak, why does it dominate? Three reasons, none of them about science. The models need it — DSGE cannot generate realistic inflation persistence without the expectations term, and dropping it would require rebuilding the toolkit of central-bank forecasting and policy simulation. It preserves the illusion of control — if inflation is caused by global oil prices, avian flu, shipping backlogs, or a structural housing shortage amplified by contractual CPI indexation, the central bank is largely a spectator. It cannot print houses, lay eggs, or drill for oil. But if inflation is caused by expectations, the central bank has a direct tool, and the framing converts the institution from a passive observer of real-economy shocks into the protagonist of the story. It shifts blame onto the public — treating inflation as an expectations problem quietly encodes that consumers are accepting price hikes too easily and workers are demanding raises too aggressively, and that the cure is to discipline them through higher unemployment. The alternative diagnoses — corporate margin expansion, fiscal choices, institutional design flaws like verðtrygging — all point at politically costlier targets.

This is where the "it's just academic" defense stops working. This is the theoretical scaffolding that lets a central bank aim a rate tool at household balance sheets, engineer a slowdown, raise unemployment, and call the resulting pain a credibility investment. The instrument is real. The people hit by it are real.

There are enough credible channels feeding into making the inflation broad based and sticky without us having to go look into psychology and surveys. We've already identified one: the feedback mechanism of inflation linked mortgages re-indexing upwards every time inflation is observed. But if the bank does want to read into survey results - maybe what the public is trying to convey to the central bank is not that the rate hikes are insufficiently large to convince them to revise expectations of future inflation downward — but that the central bank doesn't have the ability to remove supply bottlenecks, negate or unwind verðtrygging effects or prevent the next wave of foreign labor trying to find suitable rental apartments. Suspect 4 is not the culprit.