How Will Investors Know If Inflation Is Transitory Or Permanent By Steven Englander and John Davies, FX and Rates strategists at Standard Chartered Bank The Fed has indicated that it does not see its expected inflation surge in the coming months as pointing to longer-term pressures. Many investors are sceptical, but do not have a ...
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By Steven Englander and John Davies, FX and Rates strategists at Standard Chartered Bank
The Fed has indicated that it does not see its expected inflation surge in the coming months as pointing to longer-term pressures. Many investors are sceptical, but do not have a framework from which to push back against the Fed’s optimism that it can manage a "gentle inflation overshoot."
Here we argue that looking at trimmed mean inflation is a straightforward way of assessing whether an inflation surge is broad-based or narrow. So far, we find small indications that these broad-based inflation indicators are rising, but nothing conclusive. This assessment could change in the coming months.
We do not expect fixed income investors to challenge the Fed while evidence on inflation is inconclusive. Yields may rise modestly if it looks as if growth will support the start of tapering in 2022, but a steep backup of yields likely requires either significantly increased inflation concerns or growth optimism, neither of which is now visible.
We also watch forward inflation breakevens, to see if they rise above 2.3%, and econometrically derived underlying inflation calculations from the Fed. Breakevens are calculated on a CPI basis; 2.3% would correspond to 2% on a PCE basis. This is a bit of a Rubicon for the Fed, which emphasises its commitment to maintaining stable long-term inflation expectations. Forward breakevens have poked above 2.3%, but have not been able to stay above for any length of time.
The case for looking at trimmed means is that inflation is usually a broad-based phenomenon. It is not just one or two items that go up in price but an environment of general price increases. Trimmed means take out the extremes of sharply rising and sharply dropping prices, and are preferable to core inflation measures that remove food and energy only but include temporarily volatile items. The fastest-rising prices likely reflect a surge of reopening demand or supply-chain constraints. But these price pressures should emerge in a small set of industries where activity has been limited, not across the board. The Fed could argue that a broad-based increase in prices can also be transitory, but that is a hard argument to make when much of their research associates the common element of inflation with underlying inflation trends.
None of the Fed trimmed mean measures are signalling a breakout from past inflation norms (Figure 1). All are well below mid-1990s and 2008-09 global financial crisis levels, let alone 1980s or 1970s levels, so there is no signal of an inflation surge. However, these trimmed means are now close to pre-COVID levels, so further backing up could signal an exit from the ultra-low inflation norms of the previous decade. These readings would probably need to be 0.5-1.0% higher to signal a risk that broader inflation would be above 2.5%. The San Francisco Fed’s calculation of the share of PCE spending and items with rising prices is similarly in line with the past 10 years and well below 1970-2000 levels (Figure 2).
A second approach estimates the common inflation component using econometric methods to identify and weight prices that have the most movements in common. The New York Fed’s underlying inflation gauge based on CPI prices is showing clear acceleration and is at the highest level since 2008 (Figure 3). What this means is that the CPI components with the greatest common movements are going up in price relatively quickly.
By contrast, a quarterly index put together by Federal Reserve Board staff to extract the common movement in inflation expectations (presumably more forward-looking) showed modest increases through Q1-2021. This index is a mixture of inflation expectations at various tenors and has paralleled 5Y5Y UST inflation breakevens (BE) recently, so it looks likely to accelerate in Q2 (Figure 3). However, it has a very low amplitude, even compared to a 10-year average of core PCE or 30Y UST inflation BEs, so modest moves may be a much bigger signal than appears at first glance.
Fed Vice-Chair Clarida has referred to this index several times as a guide to whether inflation expectations are anchored, but the outcome is so stable it is unclear how it should be interpreted. The series begins in 1999, the low is 1.93%, the high is 2.15% and the series has rarely gone above 2.1%, so moving beyond these levels should probably be a yellow flag on the inflation front.
The recent pull-back in breakeven spreads suggests the market has become more prepared to give the Fed the benefit of the doubt regarding its view that near-term upside inflation pressure will prove transitory. During Q1, the volatility in real yields and rise in rate hike expectations suggested the market was ready to challenge the Fed on its own forward guidance on policy. A steady flow of dovish rhetoric, from Chair Powell in particular, capped the Q1 curve steepening but breakeven spreads continued to rise through mid-May. At levels around 2.75-2.85% for 3Y-5Y breakevens, the market appeared to be questioning whether inflation would prove as transitory as the Fed expected. However, the rise in 5Y5Y and 30Y breakevens was more contained and, in our view, implied the market was broadly pricing for the Fed to achieve its average inflation target (AIT) over the longer term.
In recent days, spot breakevens across the entire curve have broken below their uptrend channels from April 2020. In the process, the breakeven curve has seen some disinversion, meaning that the move in the 5Y5Y forward breakeven has been more modest than the move in spot breakevens. This makes sense, in our view – while breakevens reflecting the near-term inflation outlook ebb and flow as the pace of re-opening and recovery plays out, the market’s longer-term inflation view should become more steadily aligned with the Fed’s 2% AIT framework. The upcoming CPI report may prove crucial in determining whether this move can extend further near-term. Given how well the market digested the April CPI and PCE data, we suspect that only an overshoot on core CPI above the higher end (3.7-3.8% y/y) of the estimate range within the consensus survey would be likely to reverse the recent breakeven decline.