Faced with a stagflationary shock, the Federal Reserve is on hold. Its next move will be dictated by inflation *expectations*, measured by the 5-year breakeven rate. If expectations remain anchored, the Fed can focus on growth; if they rise, aggressive rate hikes will follow.

The Fed's concern isn't just the current high inflation rate, but the risk that prolonged high inflation changes public psychology. If businesses and consumers begin to expect continued price hikes, they may become less price-sensitive, creating a self-reinforcing 'snowball' effect that makes inflation much harder to control.

Contrary to narratives about excess demand, the recent inflationary period was primarily driven by supply-side shocks from COVID-related disruptions. Evidence, such as the New York Fed's supply disruption index accurately predicting inflation's trajectory, supports this view over a purely demand-driven explanation.

While events like the pandemic, the Ukraine war, and the Iran conflict are individually unique, their rapid succession conditions the public to expect continuous price shocks. This transforms transitory inflation into a deep-rooted psychological problem for central banks, as people stop seeing these events as isolated.

It's the volatility and unpredictability within the supply chain environment—rather than the magnitude of a single shock—that can dramatically amplify the inflationary effects of other events, like energy price spikes. This suggests central banks need situation-specific responses.

The Federal Reserve can tolerate inflation running above its 2% target as long as long-term inflation expectations remain anchored. This is the critical variable that gives them policy flexibility. The market's belief in the Fed's long-term credibility is what matters most.

While the direct impact of tariffs may be temporary, the elongated process risks making consumers and businesses comfortable with higher inflation. Combined with questions about the Federal Reserve's political independence, this could unmoor expectations and make inflation persistent.

History suggests that if inflation remains high for too long, it can alter public psychology. Businesses may become less hesitant to raise prices, and consumers may grow more accepting of them. This shift can create a self-perpetuating feedback loop, or 'snowball' effect, making inflation much harder for the central bank to control.

The narrative of "well-anchored" inflation expectations is being tested by the oil shock. The 5-year breakeven inflation rate, a key market indicator, has risen 20 basis points from 2.4% to 2.6%. This indicates investors are beginning to price in higher inflation for longer, not simply looking through the shock.