The April CPI inflation rate figure of 8.3% (year-on-year) is likely to add to anxieties about future inflation, even though it is slightly down from March's 8.5%. In our view, articles and opinion pieces that proclaim that central bankers have been derelict in their duty do not serve investors well . Instead, investors should differentiate between demand- and supply- side drivers of inflation. Our analysis suggests that the most recent data from the bond market are consistent with a demand-side inflation expectation of 2.6%, with the rest reflecting supply-side pressures.
With the emergence of higher inflation rates post-pandemic, significant commentary has been made about central bank mis-management of monetary policy. For instance, the Washington Post has featured opinion pieces on this theme by Larry Summers, and The Economist devoted a cover and a policy brief to the Fed’s mismanagement. Although these commentaries acknowledge the distinction between demand- and supply-side effects, the analysis and recommendations almost all seem to lead to demand management (or mismanagement).
Specifically, the argument is that fiscal and monetary policy have been too stimulative. The impact of the stimulus is observed in tight labor markets and wage inflation, and hence general price inflation. This analysis would imply that (a) the impact of supply-side drivers of observed inflation are small relative to the demand-side drivers and (b) market pricing of inflation expectations are flat out wrong.
Our preference is to interpret realized inflation data under the assumption that the bond market is the best initial forecast of future inflation. With this assumption, observed differences can be conveniently separated into demand and supply side effects. This structure helps us unravel whether the bond market judges the paths of monetary and fiscal policy as credible.
Exhibit 1 plots the US 10-Year (nominal) Treasury yield and the US 10-year (real) TIPS yield, and their difference from 2010-2022. We interpret the difference - the 10-year breakeven inflation rate - as the market’s expectation for inflation. What is striking about the exhibit is how little actual variation we’ve seen in the last 12 years. Although nominal rates are higher in May, 2022 than in January, 2022, the increase has largely been driven by the increase in real rates. Market-based inflation expectations have increased only 20-30 basis points since the beginning of 2022.
To evaluate policy credibility, we use government budget accounting to link inflation expectations to monetary and fiscal policy paths . In principle, less credible monetary policy and fiscal policy would lead to higher market-based expectations of inflation and vice versa.
Why would the bond market judge fiscal and monetary policy (i.e. the demand-side) to be credible? In our minds, there are three reasons specific to Fed policy, and two specific to fiscal policy. Looking first at monetary policy, here are three important Fed announcements:
Long-term growth and inflation expectations of about 1.9% and 2.0% respectively .
Seven rate hikes planned for 2022.
The start of quantitative tightening.
Given that the Fed has stated their expectations for long-term inflation (point 1), and that they control one important lever in setting inflation expectations, it is hard for us to judge points (2) and (3) as anything but adding to policy credibility.
On the fiscal policy side, there are two important points to make. First, as shown in Exhibit 2, the debt-to-gdp ratio has started to decline. More importantly, further expansion of deficit financing strikes us as politically unlikely (with the failed BBB bill and the likely GOP control of at least one side of Congress as exhibits A and B).
The bottom line is that bond market participants view fiscal and monetary policy as generally credible, and are pricing long-term inflation expectations accordingly. Indeed, on our calculations, as shown in Exhibit 3, market-based expectations are around 200 basis points lower than they would be if policy was not judged to be credible.
With market-based inflation expectations of around 265 basis points (as of May, 10, 2022), it seems clear to us that the remaining 565 basis points of reported inflation (annual inflation rate, as of April, 2022) can easily be attributable to supply-side effects. As is well known, supply-side inflation is driven by the presence of frictions to market pricing. These frictions dissipate when normal market-based mechanisms are allowed to function. The end composition of the basket of goods and services may change, but the long-term effect on general inflation should be nil. Should these frictions become further amplified, however, observed inflation could continue to rise.
Investors would be well advised to remember that demand side management is potentially ineffective in managing supply side shocks. To give a current example: chip production in China has dropped dramatically as a response to Covid outbreaks in China. It seems absurd to us to suggest that Fed policy can do much of anything about either chip production or Covid in China.
The two main issues for investors are: first, use available market-based vehicles (e.g. TIPS, inflation swaps) to manage exposures to demand-side driven inflation shocks. Additionally, they should consider investments (e.g. equities) whose long-term (inflation-adjusted) cash flows are invariant to demand-side inflation shocks.
Secondly, they should treat supply-side inflation shocks as opportunities. These shocks are produced by market frictions, and those frictions need to be resolved. Investment opportunities certainly exist in friction resolution. For example, although high oil prices are profitable for oil producers, they also provide signals for investors interested in financing cheaper substitutes. We will continue exploring this theme in future notes.
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