Everything to know about inflation and why it’s suddenly surging

Bargain borrowing is deemed essential to keeping the burgeoning recovery on track. Indeed, the most attractive mortgages rates in decades are fueling a boom in homebuilding, a key engine of economic growth. But it’s an example of how Fed policy is stoking inflation that may undo the cheap credit it has engineered. We put together a primer about all the ways the rise in inflation may start to affect your wallet—and the economy at large.

What is inflation and how is it measured?

First, a trip back to Econ 101. Inflation is defined as a decline in the purchasing power of a given currency over time. Prices are tracked via a “basket” of common goods that are periodically measured. The resulting move up or down in the consumer price index (CPI) is expressed as a percentage. If prices for the basket go up 2%, that means inflation is running at 2%. And 2% is the Fed’s target for where it would like to see inflation on an annual basis—not too hot, not too cold.

How much has inflation jumped?

Americans can be excused for getting thoroughly confused by the experts’ wildly divergent views on inflation. But one element is clear: The new CPI numbers are scary. In May, the Bureau of Labor Statistics reported that consumer prices jumped by 0.6% in May—or at a 7.2% annualized rate—and have risen 5% in the past 12 months, the highest reading since August 2008. Since May of last year, the cost of dining out has swelled by 4%, apparel by 5.6%, electricity by 6.2%, and “transportation services,” a category including airline tickets, by 11.2%. Used cars and trucks got 56% pricier, and at the gas station, you’re paying half again as much to fill your tank as a year ago.

As for agricultural commodities, corn and soybean prices have vaulted 70% and 40% respectively since the close of 2019 to reach multiyear highs. Bruce Sherrick, an agricultural economist at the University of Illinois, believes higher farm produce prices are here to stay. “People dined at home a lot more during the pandemic,” he says. “The dollars they spent shopping at grocery stores buy a lot more food than in a restaurant.” He predicts that the trend to enjoying family meals around kitchen and dining room tables will persist. The upshot, he says, is that “people will continue to spend more in grocery stores. Since the pandemic, they have an elevated interest in learning about the attributes of the food they consume at home. The fraction of the dollars spent on food going to farmers will be much higher. That’s good for farmers and food prices.”

Why is inflation spiking now?

Put simply, reopening has unleashed demand, and supply chains are still disrupted in some sectors, leading to higher prices. Some categories are seeing much higher spikes than others. May’s increase “was driven partly by a huge rise in used car prices, which have soared as shortages of semiconductors have slowed vehicle production. Sharply higher prices for car rentals, airline tickets, and hotel rooms were also major factors, reflecting pent-up demand as consumers shift away from the large-goods purchases many of them had made while stuck at home to spending on services,” according to Bloomberg.

Is the spike in inflation temporary?

According to the Federal Reserve, yes. The central bank claims that the unforeseen rampage is a passing phase. In testimony before Congress the week of June 21, Chairman Jerome Powell characterized the big new wave as “transitory.” For Powell, what’s causing the jump is the confluence of rising demand as the economy roars back and popular products temporarily in short supply. Powell noted that depleted stocks and heavy orders for computer chips and used cars and trucks have sent their prices soaring. But he predicted that production of such scarce goods will ramp up quickly, reversing the spikes. He also posits that the famous worker shortage will also soon ease, restraining today’s big wage increases. “If you look behind the headlines and look at the categories where these prices are really going up,” Powell testified, “you’ll see that it tends to be in areas that are directly affected by the reopening.”

The chairman, however, isn’t predicting how long the inflation onslaught will last, and he even admits it may not be nearly as “transitory” as his best forecast. “That’s something we’ll go through over a period,” he told lawmakers. “It will then be over.” Powell added that inflation should eventually subside to around the Fed’s long-term target of 2%, while cautioning that “it’s very hard to say what the timing of that will be,” and that “inflation could turn out to be higher and more persistent than we anticipate.”

But what if it’s not “transitory”?

Many experts believe that the U.S. is facing a hot streak that could last much longer. Or at least they think it’s a strong possibility. As early as last December, JPMorgan Chase CEO Jamie Dimon was predicting price increases of 3% to 4% for 2021, and in recent testimony before Congress he updated his view, saying, “I think you have a very good chance that inflation will be more than transitory.” Bank of America’s Brian Moynihan is also getting wary. “The great debate is whether inflation is transitory or not transitory,” he declared on CNBC in mid-June. “I think we have to be much more careful now because we’re seeing wages grow, we’re seeing sticky prices grow. Are they transitory? Probably, but we won’t know until we get there.”

Will the Fed have to raise interest rates?

Despite Powell’s soothing words, the data showing prices rising far faster than the Fed’s forecasts triggered a major shift in its strategy. On June 16, the central bank announced that the majority of the top Fed officials believe that the Fed will raise rates twice by the end of 2023. That view advances the March outlook that called for increases in 2024 at the earliest.

The reset will also alter the timing on the Fed’s second big offensive for restraining rates, its gigantic bond-buying program. The central bank is now amassing $120 billion a month in fixed-income securities; the bulk of those purchases are Treasuries issued to fund the nation’s voracious borrowing. (Generally speaking, when the Fed wants to keep interest rates low it buys bonds; the demand has the effect of raising the price and lowering the interest rates of those bonds. On the flip side, when the government wants to nudge interest rates higher, it will sell bonds, raising supply, lowering the price and causing rates to go up.)

To prepare for the rate hikes that are now coming around a year earlier than previously planned, the Fed will also need to start “tapering” or reducing its bond-buying pace sooner than expected. We’ll probably see the tapering begin later this year. Some Wall Street bankers believe that the Fed will need to move even faster. James Gorman, CEO of Morgan Stanley, believes the Fed could raise its benchmark rate in early 2022. “Increasingly people are starting to say it [inflation] may be more structural, long term,” said Gorman at a conference in late May.

What does this mean for the Fed funds rate?

For now, the Fed is continuing to hold the Fed funds rate (at which banks lend one another excess reserves overnight) at virtually zero. That ultra-easy-money stance exerts a gravitational pull on short-term Treasury yields, while its prodigious buying depresses those on longer-dated bonds. As the Fed gradually retreats, the power to set interest rates will shift back to the markets. As that happens, it’s difficult to see how the bluebird view that yields will remain anywhere near today’s levels can be correct. Yet it’s those forecasts that we keep hearing to justify lofty equity prices and the already historic run-up in federal debt. Treasury Secretary Janet Yellen, along with such distinguished economists as Larry Summers and Jason Furman, contends that today’s slender rates make it a great time to borrow trillions more.

What is the yield curve predicting?

As I wrote recently for Fortune, there’s an inflation indicator very few people are paying attention to: the yield curve. Indeed, the best road map to where rates are headed isn’t the outlook from Wall Street or the Fed. It’s what’s baked into the array of yields set by the galaxy of funds and individuals wagering money for their clients and themselves. “The yield curve is the summary of the market’s best estimates,” says Sherrick.

What’s mostly ignored is that there’s a forecast embedded in current yields for one-, three-, five-, and 10-year Treasuries. If, for example, you buy a five-year today, at 0.90%, you’ll be getting a compound return of 4.6% total by mid-2026. Put simply, the math says that the total gain on the five-year has to equal the sum of what you’d get from buying five one-year bonds in each 12-month period from mid-2021 to June 2026, reinvesting the interest each time. So if you’re starting this year at just 0.009%, less than one-tenth of one percent, one-year yields in future years must ramp fast to get a total, cumulative return from 2021 to 2016 of 4.6%.

Today, the curve is predicting much higher rates in a few years for exactly that reason: Even though yields on, say, the three- and the five-year are extremely low versus history, the one-year is so incredibly depressed by the Fed’s stimulative stance that future one-years need to jump and keep jumping to reach what you’d get holding the three- or five-year to maturity.

“The yield curve shift is signaling something that is really important,” says John Cochrane, an economist at the Hoover Institution. A plausible explanation, he says, is that inflation will be higher in the next several years than previously thought. Adds Sherrick, “We’re seeing higher expectations for inflation than a few weeks ago.”

What are other inflation indicators predicting?

Treasury Inflation Protected Securities, or TIPS, shield investors from the ravages of fast-rising prices. Their returns track inflation, so that bondholders keep all of their purchasing power when the CPI sprints. The TIPS forecast for future inflation is embodied in what’s called the Inflation Breakeven data, which forecast the rate of price increases for future five- and 10-year periods.

In the thriving economy of early 2020, the 10-year breakeven stood at 1.65%, meaning the markets expected prices to rise by an average of 1.65% a year over the next decade. But in the reopening, it has hit the highest levels in years, rising to 2.54% in mid-May, before easing to 2.31% on June 22. So investors foresee much higher inflation over the next decade than they predicted before the pandemic. And the spike to over 2.54% recently suggests that prices are in danger of rising much faster than the Fed’s 2% target.

How about the five-year breakeven? It points to higher price increases in the middle years, just what the recent pop in the two-, three-, and five-year yields-to-come are showing. In mid-May, the five-year breakeven hit 2.72% before drifting to the current 2.5%. Still, that’s the highest reading since 2008, and it’s almost a full point above the level at the start of the pandemic. So over the next few years, the investors in their collective wisdom forecast that inflation will run well above the Fed’s 2% goal.

What will happen to interest rates going forward?

You probably noticed that the yields on five- and 10-year Treasuries are lower than the estimates of average inflation over the life of those bonds. So if you buy them today, the interest payments won’t keep you even with the rising costs of everyday living. The difference between their yields, and expected inflation, is what’s called the “real rate.” Today, real rates are extremely and unusually negative. The big question is how that can possibly continue.

In most past periods, the real rate has tracked growth in the economy. “If the economy is growing, more companies borrow to invest, and you need to have Treasury rates that exceed inflation,” says Cochrane. “People say, ‘We’ll save money now because rates are attractive,’ and put off going out to dinner.” In a buoyant economy, companies and investors compete to purchase Treasuries as a safe place to park their growing profits and savings. It’s the dynamic that in most periods keeps yields on the three-, five-, and 10-year above the growth in prices, so that investors maintain the purchasing power of the dollars they invest and also pocket a small “real” gain over inflation that follows the “real” rise in GDP.

But that’s not the case today. “Real” rates have seldom been negative, let alone this deeply negative. As Cochrane explains, part of the reason is the big downshift in the U.S. economy’s performance. “Starting in 2000, America got stuck with 2% a year growth,” he says. “Low growth goes together with low rates. That we have super-low rates in a low-growth regime is not surprising.”

But as Cochrane acknowledges, that rates are actually negative and this far underwater versus inflation is surprising. “Persistently negative rates in the U.S. are a new thing,” he says. The real rate on the five-year Treasury sank into minus territory in the aftermath of the Great Financial crisis from mid-2011 to mid-2013, and the 10-year followed suit for a much briefer interval. But that happened in a horrible economy. In today’s reopening, with GDP projected to grow by 7%, the five-year at around 0.8% is languishing 1.6% below the estimate for inflation from now until May 2026. As for the 10-year, its current yield of 1.48% is projected to lag the price level yearly by about 0.80%. In other words, if you buy five- or 10-year Treasuries today, you’ll be getting paid one-half to one-third as much as your rent, medical expenses, and grocery bills are likely to rise.

Where is inflation heading now?

My bet is that the Inflation Breakeven numbers are a great guide to where inflation is heading. And it’s pointing to around 2.5% in the years ahead. But although the yield curve is flashing that rates for the same maturities will rise a lot, they’ll probably have to increase much more. The reason: Eventually, investors will want returns on Treasuries that exceed inflation, as they almost always have in the past. What happened when the Fed began to “normalize” in late 2018 provides a guide to where real rates are going. The inflation-adjusted yield on the 10-year hit 1% and looked to be heading higher. Of course, the Fed then changed course and once again flooded the markets with cheap credit over fears that the Trump tariffs targeting China would send the economy into a tailspin.

What’s kept real rates negative is the Fed’s extraordinary acrobatics. But now the central bank is pledging to start easing its yield-crunching campaign sooner than expected. As the shift happens, we can assume that real yields will return to at least 1% and, in this writer’s estimation, more likely rise to at least 1.5%, which is still below the CBO’s forecast for annual growth in GDP. So add 1% to projected inflation of 2.5%, and you get 3.5% on the five-year, and probably around 4% on the 10-year. If investors demand returns that outpace prices by 1.5%, the five-year yield would hit 4%, and the long bond would reach 4.5%.

Compare those numbers to the CBO’s latest budget forecast, issued in February. The agency predicts that the 10-year will average 2.4% from 2021 to 2031. That extremely modest number is being used by the advocates of increased deficit spending to argue that over the next decade, federal interest expense won’t rise enough to cause a problem. But if the CBO’s right, the long-bond yield will barely match and could even trail inflation. Real rates would average zero or stay negative for the next decade.

A more prudent estimate would foresee a return to the regular world where the 10-year yield equals inflation plus a point or two. But that scenario would expose the real and present danger that exploding interest expense will swamp the budget.

What does inflation mean for stock and bond investors?

The budget policies and the expectations of both bond and stock investors are ill-prepared for anything remotely resembling a future in which interest rates return to traditional levels. “The Treasury is borrowing to finance the deficits at what amounts to the kind of short-term teaser rates that folks who bought houses in 2006 took out, thinking their homes’ values could only increase,” says Cochrane. He fears that a jump in rates on the huge amounts of debt the Treasury’s forced to roll over each year could push interest expense to unsustainable heights, unleashing a crisis. “You will see intense pressure to keep rates low,” he says. “If they go up too much, you’ll have too-big-to-fail banks, a budget meltdown, and a lot of equity investors who will lose a lot of money.”

Though the Fed is underplaying the news, it’s the inflation flare-up that’s forcing Powell’s hand. But we don’t have to see a continuation of last month’s dizzying CPI numbers for rates to go far higher. All that has to happen is for the Fed to back off. Rates will eventually have to match inflation, and then some. America will gradually emerge from a fantasyland orchestrated by the Fed. That will be another reopening where the maestro withdraws and market forces take charge. The regime change won’t be pretty.