More on Inflation

Posted on Apr 1, 2021 in Economics

More on Inflation

We hear all kinds of opinions on the inflation outlook. Some economists believe factors like globalization, technological advancements, and demographics will keep a tight lid on inflation rates for many years in the future. Others believe that the massive amount of Fed monetary support and Congressional fiscal support, totaling in the many trillions, will ultimately spark inflation rates well beyond anything we’ve seen in recent decades. The ultimate authority, of course, is the Federal Reserve. The Fed believes that we will indeed see an acceleration in inflation later this year to rates above their target of 2%. However, the Fed also argues that the spike in inflation will be mostly attributable to base effects, and therefore price increases will subside sometime next year. “Base effects” refers to the fact that we will soon be cycling the severe economic damage associated with COVID. As businesses closed and much of the population resorted to self-quarantine beginning last March, aggregate demand weakened and caused a meaningful reduction in inflation. The Fed believes the unwinding of that weakness will be the root cause of higher inflation later this year – not a more systemic mismatch between supply and demand.

But I’d argue that the best indicator of future inflationary pressures is probably the bond market. We can determine what levels of inflation investors (in aggregate) expect for many years into the future by tracking the yields on fixed-rate Treasury bonds and Treasury Inflation-Protected Securities (or TIPs). The former is simply the traditional Treasury bond that pays a fixed rate of interest and matures on a fixed date in the future. TIPs, on the other hand, are Treasury bonds that include an inflation adjustment each year to compensate investors for increases in price levels as determined by the Consumer Price Index (CPI). The difference between those two yields, which are readily observable in the markets each day, determines the level of inflation that bond investors expect over that time horizon. Investors refer to these imputed inflation rates as “breakeven rates.”

In the charts below we show how those breakeven rates (red lines) have trended for the 5- and 10-year maturities. You will see that inflation expectations, as measured by these breakeven rates, have been going up in fairly uninterrupted fashion for many months. The current breakeven rate for the 5-year maturity is about 2.57% and the current breakeven for the 10-year maturity is about 2.36%. This means that investors expect inflation to be higher over the next 5 years, on average, than over the next 10 years. This is somewhat reassuring as it shows that investors are buying what the Fed is selling – any uptick in inflation over the next year or more will be transitory and then inflation will settle back into the Fed’s long-term target of about 2%.

The last chart shows that the difference between inflation expectations over the 5- and 10-year periods has subsided a bit, at least temporarily, over the past couple of weeks after shooting higher in the previous months. This is a good sign as well as it shows that any short-term increase in inflation over the next few years should not result in a crippling round of Fed rate hikes that could throw the economy into a recession. Obviously, these current market yields provide no guarantee that inflation won’t rise beyond the Fed’s comfort zone. But, at least for now, the Fed appears to have control of the bond market as well as investor expectations with regard to inflation. It would be a very good thing for investors if that remains unchanged.

We keep returning to the topic of inflation because it is perhaps the single-most important factor that will determine investor fortunes in the months and years ahead. The fine line that the Fed has been straddling has become significantly more complicated as the economy begins to open up and trillions of dollars in fiscal support are deployed. For now, it looks like the Fed is on a successful path. But as the Fed is well aware, things could change very quickly, especially if there are any policy missteps. Stay the course, stay vigilant, and stick with quality as the decades-long trend of falling interest rates may have come to a close.

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