Inflation, year-over-year, hit 7.9 percent in February.
This is a forty-year high.
The cause: the Russian invasion of Ukraine has pushed inflation higher than what was previously the case.
The future: we are in a state of radical uncertainty.
We don't really know what is going to happen in the future.
There are higher energy costs.
There are higher commodity prices.
There are supply chain issues coming from the worldwide Covid-19 pandemic.
One glances through the morning newspaper and finds even more reasons why prices are rising more rapidly than before.
And, there are the longer-term, supply-side issues that economists like Charles Goodhart have been promoting for some time.
Mr. Goodhart argues that we have entered an era where there will be worker shortages. Hence, wages must go up. Hence, prices must go up.
Mr. Goodhart has predicted, "that inflation in advanced economies will settle at 3 percent to 4 percent around the end of 2022 and remain at that level for decades."
There is a lot going on in the world right now and it is very difficult to know all the possible outcomes that might be forthcoming. Therefore, radical uncertainty.
investors seem to believe that price inflation is going to stay around for a bit.
The Federal Reserve has had a target goal of 2.00 percent inflation for quite some time now.
Jerome Powell, Fed chairman, has loosened up on the goal this last year in order to give the Fed some more room in terms of setting its monetary policy.
Still, the Fed would like to get back to this goal of 2.00 for the longer run.
But, one has to go back to January 2021 to find "market expectations" that are consistent with this longer-term goal.
My market expectations are taken from the government bond market and reflect the difference between the nominal yield on a certain maturity of U.S. Treasury note and the yield on the U.S. Treasury Inflation Protected Securities.
This spread is often referred to as the "breakeven" yield.
In the early part of January 2021, the expected five-year inflation rate built into the yields of government securities with maturities of five years was right around 2.00 percent.
The expected inflation built into yields of the 10-year securities was also right around 2.00 percent.
So, in early January 2021, investors were right in tune with the Federal Reserve in expecting inflation to remain around 2.00 percent for the next five to ten years.
By the middle of March, expected inflation over the next five years was around 2.50 percent; for ten years, expected inflation was around 2.30 percent.
In early October, 5-year inflationary expectations were around 2.80 percent and the 10-year inflationary expectations were around 2.5 percent.
By the first of November, inflationary expectations had jumped once again. The 5-year figure hit 3.2 percent on November 15 and the 10-year number was around 2.75 percent.
On March 8, 2022, new, near-term highs were reached.
For the 5-year maturity, inflationary expectations were at 3.35 percent and for the 10-year maturity, inflationary expectations reached 2.90 percent.
So, investor expectations have been rising for more than a year now, but still remain substantially below the current "actual" rate of inflation.
But, this always is what happens. Inflationary expectations always lag behind actual inflation during the time period in which actual inflation is rising.
In the current case, I would argue that investors have generally been on the conservative side of expected inflation, following the words of Mr. Powell and others who have argued for some time now that the recent upward rise in inflation was temporary and was tied to the supply chain problems resulting from the spread of the pandemic.
It has only been recently that investors have modified their view and expressed concern that the "bump" in inflation was not a "bump" at all, but a part of a longer-term rise in the rate of inflation.
To me, this whole inflation picture is a part of the dilemma that the Federal Reserve is facing.
The Fed faces an inflation problem.
The problem has become more complicated due to the Russian invasion of Ukraine.
The Fed is on record to raise its policy rate of interest by 25 basis points at its March 15-16 meeting of the Federal Open Market Committee.
The Fed is also on the record to reduce its balance sheet going forward.
And, the Fed has also created an expectation that it will raise its policy rate of interest several more times this year.
But, how can the Fed actually do all these things if the world is facing a political and economic crisis caused by what is going on in Ukraine?
The Fed cannot make the "war" effort even more difficult by tightening up on its monetary policy, raising its policy rate of interest, and reducing liquidity in the financial markets.
The stock market is already in "correction" territory and expected to decline, first because of the Fed's tightening, and secondly, because of the Ukrainian situation.
If the Fed moves aggressively to raise interest rates and fight inflation, what might happen to an already disrupted U.S. economy and a worsening world economy?
Furthermore, the federal budget situation in Washington, D.C., is already pushing the debt situation to further extremes. The federal government is going to need lots more money to support its efforts in Europe and around the world and to help Mr. Biden get some of his campaign promises passed.
Financial markets that are already in disequilibrium are going to become even more disordered with all these things taking place.
What we are seeing out in the world is not a pretty picture.
The last two to three years have been an effort to resist a pandemic and combat an economic downturn.
The Federal Reserve and the federal government have over-reacted in many, many different ways. As a consequence, the economy is in a mess right now.
The policymakers in Washington, D.C., have stimulated the economy into a place of substantial dislocation.
It was going to take some time, anyway, for the Fed and the government to get things stabilized and headed in the right direction. But, this is the lesson of history. Don't get yourself into a difficult situation because something else could happen and things could get worse.
This seems to be where we are now.
And, if Mr. Goodhart is correct, the consequences of this experience of inflationary disequilibrium could last for "the next two decades."
This article was written by
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