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posted on 16 February 2017

Will Inflation Return Anytime Soon?

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The prospects of tax cuts and an infrastructure spending package suggested by the new administration, coupled with an already low headline unemployment rate, argues, it seems, for a higher inflation rate, at least eventually. We don’t know whether a tax cut and infrastructure spending package will pass Congress, with deficit hawks reluctant to widen the gap between revenues and expenses even more than it is now.


But rather than discuss the minute-by-minute tweets and policy ideas, let’s take a look at a few metrics that might (or might not) make a difference when it comes to looking at inflation.

We can glean inflation expectations through a few methods, including:

  • Surveys asking consumers what they think inflation will be,

  • Surveys asking businesses whether they plan to raise prices (or pay more for inputs),

  • Making use of economic theory and what it tells us about the theoretical relationship between unemployment and inflation, and

  • Observing the inflation rates embedded in the prices of certain financial instruments, namely from Treasury securities and TIPS (Treasury Inflation Protected Securities), which should incorporate each of the prior three measures in market participants’ views.

1. Let’s start with the easy one first. Consumers’ expectations of inflation aren’t really expectations at all. They’re simply a reflection of inflation as it is at the time they are asked that question, as seen in the nearby graph, using the inflation expectations measure from the University of Michigan’s Survey of Consumers, which publishes these data every month. The only exception to that is in recent periods, when inflation did not keep up with consumers’ expectations, which were established over consumers’ experiences over a long history.

Click on any graph for larger image.

Inflation Expectations and Actual CPI.png

2. A second way we can glean expected inflation is by asking businesses what their intentions are to raise prices or whether they expect to pay more for their inputs. Here, we see in the Small Business Economic Trends monthly survey of the small business members of the National Federation of Independent Businesses:

“Seasonally adjusted, a net 24 percent plan price hikes, up 5 points after a 4 point gain in November. Inflation requires an environment in which demand (spending) pushes against the ability of the economy to supply output. This does not describe most of the economy with the possible exception of housing".

However, survey data like these only looks ahead over the next six months or so.

3. A third way that inflation expectations might be transmitted is through a tight labor market. Economic theory has long postulated that inflation is related to the unemployment rate, in the concept known as the Phillips Curve, which proposes that low unemployment would cause inflation to rise, transmitted through higher pay to attract and retain talent. More recently, though, this theory has been called into question because the unemployment rate has consistently fallen, but inflation has not risen in tandem. Notably, the relationship between unemployment and inflation has actually been tenuous, perhaps in large part because there are many people on the sidelines, not currently in the labor market (and thus not counted as being “officially" unemployed), but willing to jump in at any time.

Even with that caveat, we would want to look at unemployment relative to the “natural" unemployment rate. (The natural rate holds that there will always be some turnover in the labor market, and levels below the natural rate would indicate a tight labor market that might prompt large wage gains, while levels above that would indicate a labor market with slack.) What we see, though, is that unemployment falling below or surging above the natural rate has had only a loose relationship with actual inflation. We can observe the moderate correlation (higher during periods surrounding recessions), in the nearby graph that compares the actual unemployment rate subtracted from the natural unemployment rate (thereby measuring the gap between the two) and the consumer price index.

Inflation and Unemployment.png

Complicating inflation forecasting are things like oil supply shocks in both directions, ranging from the oil embargo in the early 1970s, sparking surges in energy prices, to the fracking boom, resulting in plummeting oil prices recently, to name just one. Who knows what the future holds?

Yet the markets try to foresee where inflation might be in the future, and market prices - especially fixed income - depend on those assumptions baked into, for example, bond prices. Consider the nearby graph that depicts the inflation expectations derived from comparing Treasury yields to TIPS yields. It measures inflation expectations in the five years beginning five years from now.

Five Year Five Year Forward Inflation Rate.png

We’ve examined some of the more common ways to divine inflation expectations into the future. Understanding the limitations of these tools - and there are other methods, too, besides those we discussed - means that investors may want to take long term forecasts of where inflation might be well into the future with a grain of salt. Not surprisingly, our discussion offers no views on whether inflation will be high or low in coming years.

But it pays to be vigilant about incoming data, especially those pertaining to businesses’ intentions to raise prices (or pay higher prices themselves). After all, it is businesses - particularly smaller ones that are closely in touch with their domestic customers - that might best know their customers’ willingness and ability to withstand higher prices.

Inflation, after all, requires two accomplices to businesses’ pricing intentions: one is customers, and the other is the Federal Reserve. As we’ve seen in the earlier graph showing remarkably stable inflation patterns, both consumers’ expectations and the actions of Fed have helped control inflation in recent decades. We might be encouraged that this might continue into the future.

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