Inflation Expectations Are Rising. Will Actual Inflation Follow?

The Treasury market continues to price in higher odds of reflation and the Federal Reserve remains inclined to let the economy expand for longer with little if any monetary pushback due to nascent signs of pricing pressure. That lays the foundation for higher inflation. But so far, the hard data offers minimal support. Will 2021 be the year of an inflationary regime shift?

The odds have certainly increased for firmer inflation, but it’s premature at this stage to see the rebound as something more than a modest recalibration following the sharp disinflation/deflation pressure immediately following the onset of the coronavirus crisis last spring. If there’s more than a corrective bounce brewing for inflation, the macroeconomic support will become conspicuous over the next several months. But for now, the numbers still point to a period of normalization following last year’s disinflation/deflation shock.

For some context, let’s start with Treasury market expectations. The implied forecast via nominal less inflation-indexed yield spreads continue to rise. Notably, the spread for the 5-year maturities rose to 2.27% earlier this week – an eight-year high – before edging down yesterday (Feb. 4).

Echoing the market’s inflation outlook, the Treasury yield curve has steepened in recent months. The 10-year/3-month spread is currently at 1.11 percentage points, marking a sharp U-turn from the recent descent into negative terrain.

Official inflation measures have rebounded too, although the one-year trend for consumer prices (headline and core) is still well below pre-pandemic levels. Core CPI increased 1.6% for the year through December, well below the 2%-plus trend that prevailed before the coronavirus shock.

A popular and arguably compelling narrative is that as the vaccine rollout continues and the pandemic recedes, the economy will recover and inflation pressures will continue to bubble. All the more so if the Biden administration’s ambitious $1.9 trillion coronavirus relief plan is enacted. Add to that the ongoing monetary stimulus from the Federal Reserve, with no plans to turn hawkish for the foreseeable future.

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Norman Mogil 4 weeks ago Contributor's comment

A well reasoned position on the outlook for inflation. A destruction of velocity is one of the key factors in the deflationary forces of work