Forming Inflation expectations

Konstantinos Pappas


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In today’s post we review some of the key variables that can help you forecast short term inflation as well as the main themes and drivers of inflation in the current market conditions.

Inflation Expectations CPI and PCE

The FED measures inflation using PCE, and seeks average inflation of 2%. Fed modified its monetary policy framework in August 2020. It is sticking with its 2 percent inflation target but now it intends to offset periods of below-2 percent inflation with periods of above-2 percent inflation, an approach it is calling Average Inflation Targeting (AIT).

The change makes explicit that, following a period in which inflation has fallen short of target for a time, the Fed will accept and even encourage periods of above-2 percent inflation going forward, discouraging a decline in inflation expectations. Of course all this became irrelevant during Powell’s reign as chairman.

CPI and PCE Y%Y change measures the headline inflation which is taking into account the whole basket of goods and services. Core CPI and PCE excludes volatile goods and services from the basket (mainly food and energy) providing a more stable inflation measure. Dallas Fed publishes also 2 alternative measure of core inflation Trimmed Mean PCE and 16% Trimmed-Mean (CPI) that can provide better insight on the trend.

Core CPI vs CPI
Core PCE vs Core CPI
Core PCE – Core CPI
Trimmed Mean PCE vs  Trimmed Mean CPI
Trimmed Mean PCE – CPI

When forming expectation based on CPI and PCE we have to take into account:

  1. Both metrics are lagging indicators
  2. CPI can not capture rapid changes in prices as well as PCE because weights are updated less frequently than PCE.
  3. Shelter has a delayed effect on core price inflation that needs to be adjust

Inflation Expectations based on Survey data

There are several institutions that provide credible inflation forecasts that combine economic forecast as well as experts surveys data.

Surveys of consumers and businesses :

  • University of Michigan Inflation Expectation Survey
  • The Federal Reserve Bank of New York Survey of consumer expectations
  • The Conference Board US Consumer Confidence Survey
  • Survey of Professional Forecasters (SPF) 
  • Common Inflation Expectations (CIE) – created by Federal Reserve economists which combines 21 indicators of inflation expectations, including readings from consumer surveys, markets, and economists’ forecasts.
5Y5Y Forward Inflation Expectation rate vs University of Michigan Inflation Expectation
5Y5Y Forward Inflation Expectation rate vs University of Michigan Inflation Expectation

Inflation Expectations based on financial instruments

Inflation expectations for the long term and short term are also priced in financial products mainly:

  • Break-even Inflation Rates
  • Forward Inflation Expectation Rate
  • CPI swaps

Break-even rate is the difference between the nominal yield on a fixed-rate investment and the real yield (fixed spread) on an inflation-linked investment of similar maturity and credit quality.

Break-even rates and Forward Inflation Expectation rates, are imperfect measures of inflation expectations, as they combine true expectations for inflation with a risk premium compensation that investors require to hold securities with value that is susceptible to the uncertainty of future inflation.

CPI swaps on the other hand are more targeted toward inflation than TIPS based rates as they can provide exposure to the inflation component that TIPS are desired for, while leaving behind the duration exposure.

2022 Inflation expectations: Why peak inflation is not the signal of a quick end to the inflation cycle

Now lets try to form our expectations about this year inflation and review the main drivers that can add further insights that can not be captured by the indicators we described above.

  • Supply-driven inflation

First of all with inflation coming off its highs (see PCE, CPI curves and the indices below) and supply issues starting to resolve, there is a lot talk about the Federal Reserve getting dovish. However we shouldn’t overlook the spreading effect of inflation. Inflation doesn’t tend to move linearly. Usually as certain costs rise, inflation forces different prices up over time. Furthermore, the current inflation cycle was supply driven so we should see a greater reversion to the mean of core inputs before we can expect disinflation. The supply chain issues in Chinese ports, the Oil and Natural Gas supply shock from the war in Ukraine and the recent OPEC decisions, as well as the hit in food and fertilizer supply are ongoing major factors in the global inflation levels.

DRAM contract price - Drewery shipping index- N.America Fertilizer index
DRAM contract price – Drewery shipping index- N.America Fertilizer index
Historical Standard Deviation of GSCPI (Global Supply Chain Pressures Index)

You can include these factors into your inflation expectation model by following the Global Supply Chain Pressures Index as well as oil, wheat and fertilizer indices. Although take into account that some of these indexes have their own faults for example GSCPI combines activity and price-based measures of supply stress.

  • FED policy and the state of the Economy

Target inflation

By looking at the change in break even rates we can see that there is still room for hikes till September as they haven’t changed substantially and are still 80 basis points away from the the FEDs inflation target (2%).

If most Break-even rates are close to 2% we have a well anchored long inflation target, as we see FED is moving inflation expectations to the right direction.

Quantitative Tightening

The QT impact is not clear but likely negative for the markets. In its previous attempt Fed managed to unload $800 billion of its balance sheet in 2 years which is roughly half the amount of the current QT target. What is more surprising however is that the program is supposed to end in 19 month and in its first day we saw a $10 billion increase in the balance sheet. What can we expect:

  • Interest rates upward pressure that will lead to falling assets prices in bonds, stocks, and real estate (as credit spreads will widen)
  • Unemployment will increase in the face of declining labour participation

Economic data

The Federal Reserve, latest report should provide some comfort that the economy can absorb the upcoming rate hikes. Increases in labour participation and good enough wage growth and increase in Non-farm payrolls can, for the moment, calm the concerns of or runaway inflation and imminent recession (inverted yield signals,negative corporate earnings), for the moment.

Our take on inflation

Concluding based on the current data pressure from the supply side will not be normalizing soon enough to influence the Fed. Also based on the response of inflation on the current hikes and the state of the economy there’s not much in the data to suggest a change in the policy path this year. We should expect slow and steady drop in inflation.

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