The Key To Our Inflation Problem Is Reducing Inflationary Expectations

The financial markets are comfortable with the Fed expectation that the current wave of high inflation will fade away as the supply blockages are overcome.

The acceleration of inflation in North America during the economic recovery from the pandemic has created a set of difficult challenges for monetary policy.

Among the most bizarre of the challenges is that the inflation rate in the United States (and Canada) seems to have risen because of a series of important supply shocks to the economy.

Central banks (the US Federal Reserve and the Bank of Canada) are justifiably wary of tackling the recent increase in inflation with higher interest rates because of the sense that monetary tightening is better suited to curbing a demand driven inflation problem, not a supply side inflation shock.

There is always the risk that higher interest rates could stifle the economic recovery too early in the game. As well, there is also the hope that the supply shock inflation effects will fade away later in 2022, as bottlenecks and labour shortages themselves ease.

There is always the risk that the recent escalation in consumer prices (6.2% in the US, 4.7% in Canada) will get embedded in a new and higher rate of inflationary expectations.

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In terms of trying to understand the future pace of inflation, this writer pays close attention to the inflation expectations that are built into bond yields.

After all, who is better than the fixed income player to have a sense of what the future inflation risk really is. The simple key to this is found in the statistic that an ordinary bond yield is made up of two components, the underlying real (inflation adjusted) yield plus the rate of inflationary expectations.

That is, the real bond yield is equal to the nominal yield minus the expected rate of inflation.

For purpose of illustration, I will use US bond market data on ordinary yields and the inflation adjusted TIPS yields.

The important concept in this regard is the breakeven inflation rate, which is the market-based estimate of expected inflation. It is the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity. In other words, it is a proxy measure of inflation expectations.

Since investors' money is on the line in the bond market, they have a keen interest in accurately pricing in future inflation, which should turn out to be more reliable than measures of inflationary expectations derived from survey data.

The current picture is as follows.

As of Dec. 6th, the one-year US bond interest rate was 0.25%, the five-year rate was 1.20% and the 10-year yield was 1.42%. Obviously, the yield curve is upward sloping, suggesting that the markets are expecting an increase in interest rates in the future.

The corresponding inflation adjusted TIPS yields were all negative, -1.62% for five-year bonds and -1.06% for ten-year bonds.

The five-year inflation breakeven rate is calculated by subtracting the real (after inflation) yield of a 5-year TIPS from the nominal yield of a traditional 5-year Treasury. Right now, that calculation looks like this:  1.20 (nominal yield) - - 1.62% (real yield) = +2.82%.

In other words, the financial markets expect future inflation over the next five years to average just under 3%.

With respect to the ten-year inflation rate, the markets expect just under a 2.5% average inflation rate.

In closing, it appears that bond investors are not too alarmed by the current inflation surge. They expect interest rates to rise (based on the shape of the yield curve), but they do not foresee a too alarmingly high future rate of inflation.

Obviously, bond market investors have accepted the central bank argument that the current wave of inflation will fade away next year.

Finally, it is interesting to observe that beginning in late 2010, Treasury Inflation Protected Securities (TIPS) started to trade with a negative yield.

In other words, purchasers of TIPS securities have been paying the US government for the privilege of holding its debt, rather than receiving a positive real annual yield

To this economist, there seems to be no rational explanation for an investor putting money into an investment that doesn't pay interest but charges them for holding their money. Nonetheless, this strange circumstance is the current reality.

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