Four years ago, most conversations I had with investors began and ended with a discussion of inflation.
At the time, the Federal Reserve (Fed) was embarking on an aggressive and unprecedented monetary experiment; many were convinced the end result would be 1970s-style price increases. The most dramatic manifestation of that fear was gold, at the time trading at nearly $1,900/ounce, according to Bloomberg data.
Fast forward to today: Gold prices remain 40 percent below their 2011 peak, and inflation is rarely discussed in my client meetings, except in the context of worries about deflation.
Indeed, based on the most recent data from the Treasury-Inflation Protected Securities (TIPS) market, it would seem that most investors aren’t worried about inflation. This begs the question: In a world in which slow growth and collapsing commodity prices are the most obvious economic risks, how concerned should we be about inflation?
What to Make of Today’s Inflation Estimates
My view: While there’s little evidence that inflation is going to come roaring back anytime soon, current estimates may be too low, unless you believe that the U.S. is heading the way of Japan.
Recently, according to Bloomberg data, inflation expectations, as measured by the difference in yields between the government’s TIP indices and its Treasury indices, have dropped, with 10-year expectations hovering around 1.5 percent, well below the long-term average. There are a number of logical explanations for this. For instance, the recent drop in inflation expectations has followed a drop in oil prices, as the figure below shows.
WTI OIL PRICE AND U.S. 10-YEAR BREAKEVEN INFLATION
One interpretation of this is that inflation expectations are being overly influenced by a supply-driven correction in oil. However, it’s also worth highlighting that the drop in oil prices has occurred coincident to a broader correction in commodities, itself a function of a slowdown in global growth. Apart from concerns over the global economy, other factors are also driving down inflation expectations: Evidence of wage growth has been elusive, and low capacity utilization rates suggest few factory bottlenecks to push up prices.
Other Factors Influencing Inflation Outlook
In addition, despite persistent fears of Fed-induced inflation, a deleveraging consumer and modest credit growth have resulted in sluggish growth in monetary aggregates. As of June, U.S. monetary velocity was close to a record low, while year-over-year growth in M2 is stuck at 6 percent, below the long-term average, as numbers accessible via Bloomberg show. For the inflation bulls, except for some anecdotal and episodic signs of wage inflation, there isn’t much to offer comfort.
That said, current inflation estimates probably are too low. The core U.S. consumer price index (CPI) remains stable at around 1.8 percent, despite the deflationary impact of a strong dollar and technology advances, and the secondary effects of lower commodity prices. Meanwhile, with job growth running at the fastest pace in more than 15 years and labor force participation stuck near multi-decade lows, there may be less slack in the labor market than is appreciated. This means that wages are likely to firm.
Our Take on TIPS
Finally, while the various iterations of quantitative easing (QE) have yet to lead to any meaningful inflation, as the Fed’s recent uncertainty indicates, the path to rate normalization will be difficult. How the Fed will extricate itself from a bloated balance sheet is unclear, as ultimately is the long-term outlook for inflation. With that in mind, today’s modest break-evens suggest that TIPS offer some benefit to investors looking for a long-term inflation hedge.
Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog.
