What Financial Markets Are Saying About Inflation

by: John M. Mason

Summary

Financial markets continue to see inflation remaining weak in the United States and staying well below the Fed's target inflation target of 2.0 percent.

The Federal Reserve continues to support the argument that the dip in inflation over the past two years has been temporary and inflation will return to the 2.0 percent level.

Over the past two years (or more), the Fed's record on forecasting the economy and inflation has been pretty bad while the financial markets have been much more on target.

The Federal Reserve has scaled back on its interest rate forecast for the next several years. Official projections indicate that FOMC members still believe that the effective federal funds rate will be at 0.9 percent by the end of this year; they are expecting that the rate will only rise to 1.6 percent in 2017 versus 1.9 percent in March; 2.4 percent in 2018 rather than 3.0 percent; and in the longer run that the effective federal funds rate will go to 3.0 percent and not 3.3 percent.

And, what about financial markets?

Expected rates of inflation in the Treasury's bond markets are often estimated by subtracting the yield on inflation-protected securities of a given maturity from the nominal yield of the Treasury issue of a similar maturity.

So, for example, at the close of the markets on Friday, the nominal yield on the five-year Treasury note was 1.116 percent and the yield on the five-year TIPS was a negative 0.338 percent, so one could argue that financial market participants expect the compound rate of inflation in the United States over the next five years to be 1.454 percent.

On Friday at the market close, the expected rate of inflation over the next ten years comes out to be 1.457 percent.

Well, how does this expectation coincide with the projections of Federal Reserve officials.

Fed officials are now expecting that inflation will return to 2.0 percent - the Fed's target rate of inflation - in 2018, and it will remain there for the "longer run."

How do these two forecasts match up?

Well, they don't.

At the end of April, the financial markets seemed to be expecting higher rates of inflation, 1.649 percent over the next five years and 1.738 percent over the next ten years, but in no case did expected inflation get anywhere close to the Fed's target rate of inflation of 2.0 percent.

In fact, it has been several years before investors in the Treasury bond market expected inflation to get anywhere close to the Fed's 2.0 percent target rate.

If anything, the market's inflationary expectations have been much lower this year as things seemed to be falling about in the financial market in February. Five-year inflationary expectations dropped below 1.00 percent around the 10th and 11th of February, while ten-year inflationary expectations dropped to 1.150 percent and 1.144 percent on those same dates.

Bond market participants seem to have a much more pessimistic view of the possibilities for inflation than the Federal Reserve.

The Fed's view, as often voiced by Vice Chairman Stanley Fischer, is that inflation is so low because of the aberration of very low oil prices as well as the slump in the prices of other commodities.

This view maintains that it is only a matter of time before markets revert to where they were before and this will bring inflation back into the 2.0 percent range.

Of course, the Fed doesn't want the rate of inflation to go above its acceptable target level, 2.0 percent, so even over the longer run it is not putting out expectations that inflation might rise above this level.

The financial markets, obviously, don't see this scenario developing.

If anything, participants in the financial markets seem to have a very dim view of future economic growth and this goes for Europe as well as for the United States.

So, we have the feeling that economic growth is not going to be very strong and is likely to be below the level the US economy has achieved over the past seven years, a compound annual growth rate of just over 2.0 percent.

The rate of growth in the eurozone is also below this 2.0 percent level.

As a consequence, the slow rates of growth in the economy contribute, market participants seem to be saying, to quite low rates of inflation, much below the Fed's target rate of 2.0 percent.

And, it appears that these market participants are also saying that the monetary policy of the Federal Reserve is not going to be able to do much of anything about the slow growth or the lagging inflation.

The question that comes out of this picture is about the stock market. Why is the stock market staying at levels that are near historical highs with the economy growing at such a tepid pace and with inflation expected to remain so low?

The only answer to this question that seems to fit the situation as we are seeing it, is that the looseness on the part of the Federal Reserve seems to be providing sufficient liquidity to the stock market that it remains near record levels with market participants explaining this behavior by arguing that one should not "fight the Fed."

The interesting thing accompanying this attachment to the stock market, as I have written, is that investors in the stock market do not seem to be investing much in companies or sectors or industries that might be connected with an economic recovery.

Investors, according to stock market statistics on sectors in Barron's, still, year over year, have stayed with consumer goods and consumer services. Here we see investments going into companies producing toys, tobacco, vintners and breweries, and restaurants. They are also going into utilities, not a sector that is connected with stronger economic growth.

Who is right? Officials at the Federal Reserve or participants in financial markets?

Over the past couple of years, the officials at the Fed have really performed poorly in terms of their economic projections. The financial markets have been much more on target.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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