While there are different ways of measuring and interpreting inflation, we see lower inflation ahead after a recent drop in expectations. Can the U.S. economy achieve the right level of inflation?
The highly anticipated post-meeting statement from the Federal Reserve (Fed) on December 17 brought about an intense debate over the semantics of “considerable time” and “patient,” but the central bank revealed no specific timeline for an interest rate increase even as it prepares the financial markets for the normalization of monetary policy. However, we take the Fed language to mean a continuation of monetary accommodation, at least in the interim.
But something else stood out in the Fed’s statement: the many references to inflation, which emphasized the central bank’s concerns about the lack of healthy price growth. Inflation is a classic “Goldilocks” economic situation. You don’t want too much, or too little, but just the right amount.
Inflation is something that those of us in the investment community have been talking about for a while now. While some economists worry that the easy monetary policy of recent years will eventually lead to significant inflation, it is possible that too little inflation is on the horizon, not too much.
Inflation Target: The past does not tell you (enough) about the future.
First, some background. The official inflation target is 2%, and the Fed uses the core Personal Consumption Expenditures (PCE) Index as its yardstick. The index measures actual household spending in the U.S., which reached a post-recession high of 2.1% in early 2012, but has been under 2% for the past 31 months, hovering around 1.5% since May of this year. Low inflationary pressure has justified an extension of highly accommodative monetary policy, supporting risk assets and a multi-decade bond rally.
But this backward-looking assessment says little about future spending patterns. Economists estimate inflation either using surveys or analyzing the bond market. Both methods have strengths and weaknesses, and both are telling a story of muted to lower inflation.
Survey-based Estimates: Shorter-term view is more crucial than long-term view here.
The Fed turns to survey-based estimates for inflation developments, but they have their flaws. Although these estimates include forecasts drawn from macroeconomic models, their results tend to undershoot or remain fairly flat for considerable periods of time. The stability from these surveys can be misleading and encourage policy inaction. Case in point: The Survey of Professional Forecasters, a well-respected report produced by the Philadelphia Fed regional bank, sees inflation expectations remaining well anchored at 2% for the long run, but the forecast has maintained that level through the global financial crisis, which is not an accurate representation. Indeed, over the long run, inflation may reach 2%, but in the interim, since economic activity is always a function of present economic conditions, attention should be on short-term and medium-term inflation.
Market-based Estimates: What’s wrong with 2%?
The bond market offers more clues on inflation expectations with “breakevens,” the difference between nominal yields and yields on inflation-linked bonds (TIPS). Inflation expectations in the medium term can be measured—going five years in the future—with the closely watched five-year forward breakeven rate. Since holding at a stable 2.5% early in the year, the indicator dropped below 2% in August. Even though 2% is the long-term goal, the Fed would like to see higher medium-term inflation expectations before removing the unprecedented post-crisis stimulus.
It is important that the economy be strong enough to produce its own inflation, rather than the artificial inflation spawn from the various rounds of quantitative easing. In reality, whether we analyze survey-based or market-based estimates (neither are perfect), the narrative is that present and forward inflation is not traveling in the right direction.
Why does this matter to investors? Declining inflation expectations may stymie growth, hurt valuations, impede corporate profitability and erode investor confidence. For now, too little inflation remains a bigger risk than too much.