Boston - Last week's inflation report came in much higher than expected — the Consumer Price Index (CPI) was up 0.8% month over month (including food and energy), for an annual rate of 4.2%. The market had been expecting a monthly increase of 0.2%. From a statistical perspective, that's a "miss" of 10 standard deviations to the upside.
Since the inflation figure was released, the topic has dominated the financial media, with features in most of the major news outlets. And there has been no shortage of discussion within the financial community. The big question, of course, is whether we on the verge of a stretch like the 1970s and early 1980s, when inflationary psychology took hold broadly. In April 1980, the CPI peaked at 14.6% year over year.
The short answer, in my view, is no. But there clearly are increasing risks of exceeding the 2% target of the U.S. Federal Reserve. The Fed's view is that most of the inflationary pressures are transitory, like used car prices, supply constraints and "base" effects related to the low-number price comparisons from a year ago.
However, once you factor in other elements, such as massive fiscal and monetary stimulus, the success of the vaccines and the large pent-up demand in the economy, I believe the distribution of possible outcomes is certainly skewed to higher inflation, even if my modal estimate of inflation is close to what markets are currently pricing in.
Another big question is how much of current inflation concerns is priced into market valuations. With the high level of interest focused on it, clearly some is priced in — the yield curve has steepened and the breakeven rate, which measures current inflation expectations, has risen.
But at the same time, if we look at inflation expectations over the next five years, we see an increase in the near term and then a reversion back down to around 2.6% over the longer term. The chart below, based on inflation swaps, shows the spot curve with inflation higher now and then settling down. The one-year forward rate, which looks past the current one-year jump up, stays mostly flat at under 2.6%.
Inflation swap markets don't predict an inflationary surge
Source: Bloomberg, 05/19/2021.
It's also important to remember that both Treasury Inflation-Protected Securities (TIPS) and inflation swaps markets are based on the CPI. The Fed's preferred inflation measure, personal consumption expenditures (PCE), typically is 0.3% to 0.5% lower than CPI so a market-based forecast of 2.6% is only slightly above the Fed's target of 2% core PCE — which they have stated they want to actually exceed somewhat given their new average inflation targeting (AIT) framework.
I think the right way to interpret this is that while inflation is working its way into investors' consciousness, we're not really seeing it in a way that would drive prices higher from a persistent perspective. Having said that, it's also true that the Fed is dovish and wants to lower unemployment across all segments of society, without seeming to be worried about financial markets trading at elevated levels. All inflationary risks skew to the upside.
Bottom line: We're past the first inning in terms of inflation returning as a concerning factor for investors, but we're certainly not in the ninth. From where I sit, it feels more like the fourth or fifth inning, with plenty of room to go.