Inflation Is Priced Into The Markets
Summary
- Market-based measures of inflation indicate that it will remain quiescent.
- Labor markets show little, if any, indication of wage inflation.
- Recent increases in commodity prices and treasury yields have occurred many times in the past 3 decades, without spurring inflation.
Today's headlines permeate with commentary on price inflation. Daily gyrations in stock and bond markets are typically ascribed to changing expectations of consumer price pressure. Many influential financial observers have voiced their fears of an "untethering" of inflation expectations. There are indeed signs that the rate of price increase is increasing. However, we've seen many of these signals in the last 35-year post-inflationary period. They have not proven decisive. Let's review some recent history.
It's easy to say or write that inflation is coming. Indeed, the return of higher inflation is a statistical likelihood, given that there is an underlying volatility to price levels. The real question is "how much inflation" and whether there are tea leaves out there that one can observe now that portend accelerated price increases.
Recent History
Discussion of inflationary pressure in the news media typically relies on recent histories of macroeconomic variables. There has been a focus on government bond yields and current federal spending levels. These are eminently observable phenomena. Alarmist news stories about inflation typically cite some version of a daily chart of the ten-year treasury yield. Indeed, it has climbed significantly this calendar year as investors have demanded higher bond returns to compensate them for heightened inflation expectations.
Inflation alarmists also point to the large fiscal and monetary stimulus plans implemented since the onset of the pandemic. Large infusions of cash into the system threaten increases in prices. And let's be clear, alarmists are right about the high level of government intervention in the American economy.
Recent economic stimulus has no post World War II precedent. Congress has passed economic stimulus worth about 27% of GDP in less than one year! Commodity prices are up about 60% since May.
Former Secretary of the Treasury Larry Summers opined early this month that US inflation risks are as high as they have been in decades. He pointed to the confluence of the massive stimulus and a resurgence of demand as the US emerges from the pandemic shutdown.
Yet financial markets that price out inflation expectations remain surprisingly quiescent. The real yield on Treasury inflation-protected securities (SCHP) can be subtracted from the yield on nominal treasuries (AGG) to reveal a forecast of future inflation expectations. It's called the "breakeven inflation rate." That rate, viewed in historical context, is hardly alarming.
Key Measures of Inflation Remain Quiescent
Future inflation expectations are quite similar to those which prevailed prior to the Great Recession. How can this be... with all the money the government is adding the financial system? Money supply is only part of the inflation equation. The rate at which money works its way through the system is also critical to price levels. This rate is called the "velocity of money."
Money velocity is the speed with which it changes hands within the economy. Note the precipitous drop at the onset of the pandemic. Makes sense. People simply had no opportunity to spend money. Banks weren't making loans. Essentially, cash is building up in the system as government money printing has diminished effect. The increase in money supply has been offset by clogs in the financial system.
While commodity prices have ratcheted up in the past year, this is hardly a new phenomenon. Commodities are highly volatile and swing from one extreme to the other with regularity. A more reliable portent of inflation pressure is labor cost as labor comprises a larger fraction of the value-added chain. These costs remain anchored to recent norms. Civilian compensation cost increased only 2.5% in 2020 after increasing 2.7% in 2019.
Look at the recent history of labor cost movements below. It hardly looks like inflation pressures are mounting.
There are still 10 million fewer jobs in the US economy than there were 12 months ago. Labor markets are becoming increasingly linked around the world. The current environment hardly suggests that workers will have a lot of bargaining power in the near term. It's difficult for inflation to gain traction without wage increases.
When in Doubt, Follow the Money
Sure, the most recent 12-month trajectory of economic variables suggests that there are heightened price pressures in the economy. Market-based measures of inflation have appropriately reflected those pressures. The 5-year breakeven inflation forecast has risen from about 0.6% to 2.5%. That's a real shift in the pandemic era but hardly new ground when viewed in the context of recent decades. Policymakers have stated that they are willing to allow inflation to run slightly above their erstwhile target of 2.0% to build a more inclusive workforce. They have NOT ruled out raising rates should inflation appear to be spiraling.
Market-based forecasts of inflation are to be taken seriously. Investors are effectively betting billions of dollars on their accuracy. Academic research concurs. Ribeiro and Curto (2018) studied market-based measures of inflation in Europe and found them superior to survey (talking head) forecasts. See below from their abstract:
"Additionally, we compare the predictive ability of inflation swaps with other measures of inflation expectations. The in-sample results show that, in contrast with surveys, market-based measures are able to accurately forecast inflation rates"
Financial markets are largely efficient. Be skeptical of those who try to convince you that their peculiar outlook is superior to a consensus forged by billions of dollars of traded securities. Opinions backed by money are typically more reliable than opinions uttered for the sake of garnering attention.
This article was written by
Analyst’s Disclosure: I am/we are long AGG, SCHP. 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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