Unlike Diamonds, Inflation is Not Forever But May Prove Sticky

Amid the current financial scare, fueled by anxieties about economic overheating, it is easy to forget that, until recently, prices were well-behaved and central bankers struggled to lift them sufficiently to meet their 2-percent target. Indeed, many developed and even developing countries had experienced over a long stretch of time disinflation, characterized by progressively lower price pressures and some, notably Japan, had been caught in a protracted deflationary spiral.

Financial markets can live comfortably with creeping inflation but less so with its galloping and hyper counterparts. The latter is particularly disruptive and capable of wreaking havoc on virtually all asset classes. At present, most developed countries are saddled with the galloping variant, with central bankers accelerating the pace of monetary tightening to prevent it from becoming embedded in consumers’ and businesses’ psyche. Investors in risk and low-risk assets alike are paying the price in the form of a significant erosion of their wealth.

Whether and when the trend can be reversed is a question that looms large on the financial and public policy agenda, because price stability is a prerequisite for economic vigor and political calm. Inflation is difficult to forecast in the current environment due the influence of unquantifiable variables such as Covid-inspired lockdowns, partial deglobalization, Putin’s imperialist ambitions and tactics, Sino-American economic wars, and the Great Resignation involving large-scale departures from the labor force. Inflation swaps are probably the most effective indicator,[1] but only for traders with a short time horizon.

Consumer and business inflation expectations surveys may shed light on the medium-term evolving patterns and TIPS (Treasury Inflation-Protected Securities) for up to 5-10 years. It is reassuring that both consumers[2] and businesses,[3] who have their ear close to the ground and for whom price pressures are a concrete rather than an abstract problem, believe that inflation has peaked and is headed to mid-single digit levels and possibly below. Both the 5-year[4] and 10-year[5] TIPS breakeven inflation rates are signaling that the long-term investor may look forward to a return to the 2-percent “old normal.”

These products of crystal gazing are the most reliable of those available, but they are not foolproof. In addition to the imponderables highlighted above, proper account should be taken of the potential impact of other unquantifiable factors such as the high cost of decarbonization, all which are a source of inflationary impulses. The global supply chain pressure index, which reflects supply-side constraints, remains at elevated levels.[6] It is thus a mixed picture, with the most likely scenario featuring long-term inflation above the 2 percent optimum but not substantially so. If that outcome materializes, this should be a moderately favorable backdrop for long-term investors in real assets, such as commodities, equities, and property but more challenging for those positioned in the fixed-income space.

[1] See https://www.newyorkfed.org/medialibrary/media/research/epr/2013/0513flem.pdf.
[2] See https://www.newyorkfed.org/microeconomics/sce#/.
[3] See https://www.atlantafed.org/research/inflationproject/bie.
[4] See https://fred.stlouisfed.org/series/T5YIE.
[5] See https://fred.stlouisfed.org/series/T10YIE.
[6] See https://www.newyorkfed.org/research/policy/gscpi#/overview.

Leave a Comment

Your email address will not be published. Required fields are marked *