Is Inflation Where It’s Supposed To Be? Where Is The Expected Inflation?

Jun. 09, 2016 11:02 AM ET
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Contributor Since 2016

I enjoy correlating macro-economic events and specific industry trends to determine the direction of an industry. I have been following the financial markets for over 10 years and been an active investor for the last 7 years. My industry focus are private equity, real estate, and technology, but I do enjoy applying unique valuation analysis techniques on all industries, especially if there has been some significant changes due to macro-economic drivers. My professional experience has been working as private equity and M&A associate, research analyst, capital markets analyst, and technology project manager. I started my career with a Fortune 500 engineering firm after earning an engineering degree from University of California, Berkeley.

In my previous article, The Status of U.S. Credit Market (link here), I discussed several risks and behaviors shaping the current environment in the U.S credit markets. Another important metric that needs to be looked at is inflation, especially within fixed income. Last year, there were tremendous concerns over the low inflation numbers coming out of the U.S. Although it was not technically deflationary, it still raised concerns over having prolonged ultra-low inflation or disinflation when the monetary policies of the Federal Reserve should actually support inflation. Several drivers that have been curbing inflation are depressed oil prices, low wage growth, and stronger dollar.

The inflation headline figures did slightly change in the recent months, but is this all the inflation that was expected based on the magnitude of actions taken by the Federal Reserve?

Figure below is the year over year change for consumer prices (CPI), a measure of prices paid by consumers for a basket of consumer goods and services. The CPI growth rates represents the inflation rate.

  • Figure 1. Consumer Price Index

Generally, the overall market consensus has missed target inflation for the most part of 2015.

The breakeven inflation rates on Treasury Inflation-Protected Securities (OTCPK:TIPS), which can depict market's expectation for inflation, shows that the market missed the inflation figures consistently from last year in the figure below.

  • Figure 2. U.S. 5 Year TIPS breakeven versus CPI

Clearly, the market does not believe that inflation is where it is supposed to be or that it has behaved according to the actions taken by the Federal Reserve.

The actions taken globally by Central Bankers has also been undermining Federal Reserve's efforts to lift U.S. inflation. The record levels of low interest rates, and Quantitative Easing in Europe, Japan, and China has offset actions taken by the Federal Reserve since it has strengthened the dollar compared to other currencies.

Besides the headwinds over the past year, I believe that inflation is now positioned to gain some uptick. Although, the situation can change due to the global dynamics, the upside can still come from several drivers that until recently did not support inflation. The inflation supporters will be the rise in oil prices which recently saw a bottom and wage growth, which is set to rise as the market expects more tightening in the labor force. Overall, we are at a point that the inflation upside is greater than the downward pressure caused from global currency devaluations that has been promoting appreciation in the U.S. dollar.

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