Inflation Is Coming, but How High and for How Long?

3/18/21: The volatile blend of pent-up demand, a stockpile of household cash and government stimulus checks is expected to erupt into a price spike later this year as the US economy emerges from its year-long lockdown. Already, food prices are 3.5 per cent higher than they were last year, according to last week’s inflation report from the Bureau of Labor Statistics. Energy prices are 2.7 per cent higher, and helped boost the cost of utilities 3.2 per cent higher over the last 12 months.

Current inflation readings, however, are quiescent. With vaccinations running at a 2.2 million daily rate, it will take an estimated six months – or until around September – to reach herd immunity, when 75 per cent of the US population will have received two doses. Thanks to the one-dose Johnson & Johnson vaccine, reopening could occur sooner than that. Economists have understandably ratcheted up their forecasts for growth and inflation. Real growth is expected to top 6 per cent in Q2 and Q3 of this year, according to Bloomberg survey data. The year-over-year inflation rate is expected to hit 3 per cent in Q2. The bond market suggests economists’ growth and inflation estimates could be too low.

The prospect of stronger growth coupled with higher inflation has shaken bond investors, a group who thrives on low growth, no inflation and poor economic news. The benchmark 10-year Treasury yield spiked to 1.7 per cent from below 1 per cent at the beginning of the year. The move crushed long-dated Treasuries, driving their prices down more than 13 per cent for the year so far.

Bond investors have raised their inflation expectations accordingly. The five-year inflation rate, as implied by the yield differential between fixed-rate and inflation-protected (TIPs) five-year yields, suggests a 2.6 per cent annualized rate. That’s a 12-year high.

While there’s general agreement that prices will likely climb later this year, the market’s underlying assumption, however, is that the inflationary forces we experience will be temporary and will revert toward their longer-term trend in 2021. Nonetheless, today’s inflation projection, based on TIPs trading, is substantially higher than it was pre-pandemic. Today’s bond market participants expect the longer-term inflation rate to remain comfortably above the Fed’s stated 2 per cent target.

What does this mean for Fed policy?  The US central bank has signaled patience while acknowledging our near-term economic growth prospects. The Federal Open Market Committee at its meeting on Wednesday decided to hold the line on interest rate hikes until 2023. This is despite the fact Fed officials now predict that the US will grow by 6.5 per cent this year, compared with 4.2 per cent in its December forecast. Fed funds futures contracts look for Fed tightening to begin toward the second half of 2022 and for the Fed to hike at a steeper rate than what was projected last month. Nonetheless, it appears the market is still projecting monetary foot dragging from Powell & Company.

The key question for monetary policymakers and investors is: will the inflation flare-up be temporary or sustained? The financial markets are clearly on the temporary side of the argument, and history is on their side as well. Too often, the market has been frightened by dire inflation forecasts. The last such scary outlook occurred in 2009 when the Fed embarked on quantitative easing, an experimental program in which the central bank attempts to tamp down intermediate interest rates by buying longer-dated Treasuries and mortgages directly. The prospect of massive monetary creation led economists and market participants to brace for a price spiral. TIPs pricing at the end of 2009 implied a nearly 3 per cent inflation rate in 2010 and, notwithstanding a 2011 dip to below 2 per cent, a sustained inflation rate well above 2 per cent. Yet inflation remained pretty consistently below 2 per cent over the next decade.

A few factors weigh toward higher sustained inflation. First is the jobs market. Continued inflation cannot occur without wage growth. With nearly 10 million employees out of work, it’s hard to imagine wages picking up. While the unemployment rate is currently situated at 6.2 per cent, economists, including Treasury Secretary Janet Yellen, are forecasting full employment in early 2022. Second is the possibility of instituting a $15/hour national minimum wage. In 2017, 542,000 US workers aged 16 and older were paid the prevailing federal minimum wage of $7.25/hour, according to the Bureau of Labor Statistics. About 1.3 million had wages below the federal minimum. Together, these 1.8 million workers with wages at or below the federal minimum made up 2.3 percent of all hourly paid workers. A substantially higher minimum wage would not only boost the wages of the 1.8 million workers, but it would establish a floor that would likely boost the wages of millions of other workers earning more than $15/hour currently. The last factor is experience. Inflation expectations is a critical ingredient of sustained inflation. The last time inflation trended sustainably higher was more than 40 years ago.  I started in the investment business in 1982 and I experienced this difficult period, but there are very few investment professionals active today who share that experience. Perhaps that explains the results of a recent inflation survey by Deutsche Bank, which found that investors age 55 and older expect inflation will rise to roughly 2.75 per cent, the highest expected level since 2014. Investors aged between 18 and 34 see price growth reaching about 2.3 per cent. The difference in inflation expectations represents the widest gap between younger and older Americans in survey history.

We’re going to continue to monitor inflation trends while looking for evidence that some of the embers we witness later this year won’t spark a conflagration.