US Inflation Expectations Decline Sharply

A Sudden Trend Change

Earlier this year, inflation expectations – this is to say "expectations regarding the future rate of change of CPI" – rose sharply from a multi-year low posted right at the beginning of the year. In recent weeks this trend has reversed again rather noticeably.

Image via dallasfed.org

Below is a chart of the 5 year break-even inflation rate illustrating the situation. This break-even rate is derived from the yield differential between fixed and “inflation-protected” treasury bonds. It currently stands at just 1.27%:

5 year break-even inflation rate: plunging again after the surge earlier this year – click to enlarge.

The reason why this is of interest is that the central planners at the Fed have recently let it be known that while they are no longer concerned about unemployment, they are now focused on “inflation” – Fed vice chairmanStanley Fisher made remarks about that in an interview on Monday. In other words, he prepared the markets for yet another postponement of the long telegraphed first baby step rate hike that is supposed to finally take administered rates out of the “ZIRP” zone after 6 years.

Interestingly, longer term inflation expectations have never really taken off this year. The 5-year/5-year forward inflation rate shown below (which is derived from swaps markets and essentially represents an estimate of what 5 year inflation expectations will be 5 years hence) did increase a bit as well earlier this year, but with a lot less verve. Now it is declining again as well.

5 year/5 year forward inflation rate – wallowing near multi-year lows – click to enlarge.

10 year treasury note yields are directionally aligned with inflation expectations, with a slight lag:

10 year treasury note yield – directionally aligned with market-based expectations of future CPI, but slightly lagging – click to enlarge.

CPI is of course not a “measure of inflation” in the traditional sense. It purports to measure the so-called general price level, or its corollary, money’s purchasing power. The general price level is a non-existent mathematical construct that is actually not measurable. There are countless arrays of money prices, but these cannot be just added up to produce a sensible number.

It is true that money has a certain purchasing power and it is also true that central banks have utterly destroyed its purchasing power over the past century. However, in spite of its special role as the general medium of exchange, money is a good like any other with respect to how its exchange value reacts to supply and demand. Since neither the exchange value of money itself, nor that of the goods it is exchanged for are fixed, there is no constant one can employ for the purpose of measurement.

If one really wants to find out how fast money’s purchasing power is actually declining, it is generally best to canvass housewives. Their answers are likely to be more informative than those provided by government statisticians, or any other statisticians purporting to “measure inflation”.

Monetary Inflation Continues Apace

The traditional definition of inflation has always referred to the growth rate of the money supply. This definition has mainly been changed so as to deprive us of a perfectly suitable name for what inflation actually is – the very thing that inter alia can cause prices to rise. In order to avoid confusion, we are referring to it as monetary inflation. Monetary inflation can be measured quite accurately and is currently far higher than the “price” inflation rate expressed by CPI.

US money supply TMS-2, annual rate of change. In spite of the end of “QE”, monetary inflation remains at a very brisk 8.4% per year – however, it is no longer as brisk as it once was.

As an aside, we don’t doubt that most consumer prices are rising at a significantly slower pace than monetary inflation at present. There is no one-to-one relationship between changes in the quantity of money and the prices of consumer goods. The most pernicious effect of monetary inflation is actually that it distorts relativeprices, as money always enters the economy at specific points. It doesn’t reach every sector or every person at once. Certain actors have first access to newly created money, while others only receive it later or not at all.

Obviously, many things are in fact rising in price rather quickly – titles to capital such as stocks (and we can infer from that, the prices of capital goods as well), art works, house prices, etc.

The manner in which money propagates through the economy among other things redistributes wealth from later to earlier receivers, as prices will only react with a lag to newly created money being spent. The above mentioned distortion of relative prices in turn causes the boom-bust cycle. It falsifies economic calculation and thus engenders capital malinvestment. Innocent bystanders will eventually always pay a price – e.g. from the last boom-bust cycle we still have countless mortgage borrowers that are “underwater” and many unemployed people, who are no longer officially counted as unemployed, but nevertheless somehow still remain out of work.

Below is a chart of the money stock TMS-2 and total outstanding bank credit. As can be seen, the Fed has inflated the money supply directly for several years, while the rate of bank credit inflation slowed. Recently, the situation has reversed again. This explains why money supply growth has not collapsed after the cessation of “QE” – banks have begun to issue fiduciary media at an accelerating pace (bank credit inflation stands at 12.8% p.a. at present).

TMS-2 (black line) vs. commercial bank credit outstanding (blue line)

If the decline in inflation expectations continues to gather pace, it may eventually crimp the willingness of banks to issue more credit. One reason for the decline in inflation expectations is after all that there are already busts underway in certain sectors. This is especially true of the commodities sector, of which the energy sub-sector has been a recipient of truly vast amounts of credit in recent years. We imagine that neither banks nor investors are as eager as they once were to continue lending to this sub-sector.

It is possible that this potential feedback loop may be balanced out by lending to other sectors (for instance, as noted above, there are ongoing increases in house prices) – this remains to be seen. It is interesting that the problems of the commodities sector have actually been caused by a slowdown in monetary inflation in yet another country – namely China. The sharp slowdown in China’s money supply growth has undoubtedly been instrumental in the decline of commodity prices – which has unmasked the degree of malinvestment in the sector.

There are hints that the rate of inflation of the broad money supply in the US may soon decline as well, as narrow money supply growth has recently fallen further to just 6.15% – a far cry from the nearly 25% recorded in late 2011:

The growth rate of M1 has fallen from almost 25% in 2011 to just above 6% today – click to enlarge.

Conclusion

The data shown above suggest that a future easing of Fed policy may be actually more likely than the long-anticipated tightening. It may well be that the Fed will hike just once so as to preserve its vaunted “credibility” – after all, it shouldn’t really matter if overnight rates go from nothing to almost nothing. We fell pretty sure though that the instincts of most FOMC members are telling them to ease again. After all, they are suffering from extensive “Ghost of 1937” paranoia.

Charts by: St. Louis Federal Reserve Research, StockCharts