The Whites of Their i's

Markets Grapple with Changes in Inflation Expectation, or the Whites of Their i's

i, the destroyer

Fear is a greater evil than the evil itself


Inflation has been getting a lot of attention this week and month, especially as the United States Congress passed and President Joseph Biden signed into law the American Rescue Plan Act, a $1.9 trillion disaster relief and public health funding bill. General interest (as measured by google searches for the term "Inflation") hit a five year high two weeks ago, presumably as people try to determine what its impact will be on the general price level.


i, which typically stands for the rate of inflation in financial maths, is the rate at which the general price level for a standardized basket of goods increases over time, typically one year, and measured in percentage. It's a measure closely watched by policy makers and financial markets alike, as it is a valuable indicator of economic activity and the balance of supply and demand. Inflation presupposes that a basket of goods has essentially two values: its real value, and its nominal value. Real value can be understood as intrinsic value, whereas nominal value can be understood as real value plus the change in the general price level. The higher the inflation rate, the lower the real value, and this is why inflation is considered a bad thing for an economy. Of course, too little or negative inflation (disinflation or deflation) are also bad things for an economy, so monetary and fiscal policymakers attempt to chart a course between the Scylla and Charybdis of too-high and too-low inflation:

In medio tutissiumus ibis

too high of inflation, and a person's take-home pay isn't enough to buy groceries or pay the heating bill; too low of inflation, and the burden of debt increases relative to income.


There's no hard and fast rule as to what the right level of inflation for an economy is, but central banks in the developed world, pursuant to their remit to promote price stability, have conducted monetary policy consistent with a target inflation rate of +/- 2% per year. The thought is that no one gets their knickers in a twist if a loaf of bread costs .02 more per dollar over the course of a year. Their cost of living wage increase was probably 2-3% anyway, and the change in price is probably too small to notice.


The United States has seen lower-than-target inflation for the past decade, averaging 1.7% per year over that time. In 2020, inflation registered an anemic 1.3%, reflective of the fact that the economy was in a pandemic-inflicted recession which saw huge declines in consumer discretionary spending. (Inflation is generally of one of two types: demand-pull, where elevated demand spurs price increases; and cost-push, where higher input prices reduce the amount of a good supplied to the market.) The fall in inflation was a demand-pull effect, wherein lower consumer demand resulted in a surplus of supply that the market could only clear by lowering the price. The most recent Consumer Price Index (CPI, a standardized basket of goods on which the official inflation rate is calculated, sampled and calculated by the US Bureau of Labor Statistics) showed a monthly increase of .4 percent--a tick upward, certainly, but well within a normal and expected range of values for the time of year as well as position in the business cycle (an economy emerging from recession and returning to growth.)

Signal or noise?

The issue, of course, is that actors in economics don't drive looking in the rearview mirror. They react to what lies ahead of them, which is to say that their expectation of price change matters more than the actual price change. And so it is that inflation expectations drive price change, rather than prices themselves. We can see what the change in inflation expectations by looking at the difference in price between a nominal government bond, and an inflation-protected government bond (the "Breakeven Inflation Rate".)


On the way up

In the chart above, you can see that inflation expectations are trending upward, and that the market is pricing in inflation of 2.25% over the next ten years. That's a bit higher than target, but certainly not in the let's-start-hoarding-consumer-goods threshold that is so concerning to policymakers.


With the passage of last year's and this year's disaster relief bills, presumably to be paid for by the printing of money rather than collection of taxes, market participants seem to be worried that expectations of higher future inflation will drift higher, and drag actual inflation higher along with them. As higher inflation is bad for holders of debt (it's worth less when the dollars that get paid back are worth less), bond prices fall and yields rise when inflation expectations increase. Over the long term, equities tend to keep pace with inflation, albeit with a small lag. Companies are typically pretty good at passing along higher prices to their customers, since if they don't they go out of business. Commodities offer inflation protection similar to equites, but without the lag. Of course, this means that they also are the first to fall in value as the business cycle turns from late expansion to early contraction.


As previously mentioned, inflation has been below-trend for the last decade, and despite a few theories, no one knows why. Federal Reserve Chairman Jay Powell has said that the Federal Reserve won't move to increase interest rates until they see full employment and inflation that comes in consistently above target. This gives monetary policymakers quite a bit of runway to get the plane off the ground and flying again before they have to start worrying about overheating the engines. While we believe that higher inflation is on the way, we do not believe that it will approach unsustainable levels, and that the productivity growth that disaster relief and increased consumer spending will engender should more than compensate for inflation acceleration. That said, goodstead doesn't make its living by predicting the future. Our portfolios are built to perform about the same in high- and low-inflation environments. We hope that our Members sleep better knowing that.

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