Are Structurally Lower Inflation Expectations Starting to take Hold?

A primary concern of central bankers is that in a deflationary environment consumers change their expectations regrading the future level of prices. The worry is that consumers put off today’s consumption because they believe they will be able to buy the same product at a cheaper price tomorrow. This is the inverse of what occurs in an inflationary environment where consumers are eager to spend money today in order to take advantage of lower prices that they ‘know’ won’t be there tomorrow (or they ‘know’ that their money won’t be worth as much tomorrow). The belief is that when the deflationary mindset takes hold it is very difficult to break (see: Japan over the past 25 years).

Now before we get to far ahead of ourselves we aren’t suggesting that the US is currently in a deflationary era. Deflation has definitely been a concern since the TMT bust but core-consumer prices have continued to increase by 2% annually over the past 20-years. What has changed, however, is that inflation expectations seem to have taken a structural step lower since the beginning of 2015.

Inflation expectations can be flushed out by either looking at market derived expectations (TIPS breakeven inflation) or by looking at surveys. Regardless of the source, the message is the same at the moment: inflation expectations are falling. Since the beginning of 2015, TIPS derived breakeven inflation expectations have remained below 2%. Granted, inflation expectations are above 2016 lows, however, 30-year breakeven inflation expectations are still at just 183 bps. 5-year, 5-year forward breakeven inflation expectations (i.e. inflation expectations for 5-years starting 5-years from today) are also below 2%. This series has been under 2% for about a year and has been stuck in its lowest range ever outside of the financial crisis. Historically, 5-year, 5-year forward breakeven inflation has oscillated around 2.5%.

The survey data continues to trend lower as well. The University of Michigan’s 5-year median inflation expectations survey broke to an all-time low of just 2.4% in October. The same survey also asks consumers what they believe the change in prices over the next year will be. Consumers also believe that prices will increase just 2.4% over the next year. This survey is currently at one of the lowest levels that it has been at during the recovery and the current level is a significant step down from the nearly 5% expected price increase in 2010. Finally, the consumer confidence survey that was released today showed that the average expected inflation rate over the next 12 months will be 4.8%, down from 5% last month, and significantly lower than the 6.5% expectation in 2011.

One simple reason why expectations have fallen so much is that there just hasn’t been much in the economic data to move expectations higher. In fact, according to the Citi Inflation Surprise Index, inflation data points have consistently come in under expectations consistently for the past 3-5 years depending on the location. In the US, inflation surprises have been negative (except for a brief month in 2014) consistently since 2012. In the Developed World, inflation surprises have been negative since 2013. And in the Emerging Markets, inflation surprises finally moved positive for a minute in 2016 before turning back over. Other than for that brief reprieve, inflation surprises have been negative since 2013 in EM. Lastly, our simple World CPI and PPI proxies have also been stuck in a low range since 2015. The World CPI proxy has been bouncing just above 1% sand the World PPI proxy has been below 0% since 2014. These are both remarkably weak growth rates considering that global economy has been in expansion during this period.

Are Structurally Lower Inflation Expectations Starting to take Hold?

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