The CPI print of 8.5% in March, the highest reading in over four decades, has stoked fears that the U.S. is entering a prolonged period of high inflation reminiscent of the mid-to-late 1970s. The investors who make well-informed bets on where inflation’s heading, however, take a very different view. They’re indeed expecting the current run of mid-to-high single digit increases to persist through most of 2022. But thereafter, the markets are forecasting a tapering to around the 2% range (that’s actually below the average for the five years preceding the onset of the COVID).
Sounds reassuring, right? Not really. The jackrabbit leaps that will continue well into 2023 will lift the the cost of groceries, rents, air fares, gasoline and most of the staples on families’ shopping lists to a plateau high above pre-pandemic levels, in sudden shocks. Even though inflation will taper down from there, Americans––according to what the bond markets predict––will face a price level in April of 2027 that’s almost 20% above today’s. That’s double the increase in the half decade preceding the pandemic. And if the Fed moves too slowly, and inflationary expectations become entrenched, it could turn out that the markets are taking too rosy a view, and that the cost-of-living plateau goes even higher. “The surge in the price level would well be a one-shot deal, but still a big deal,” says William Luther, an economics professor at Florida Atlantic University. “High inflation isn’t permanent, unless the Fed continues to engage in expansionist monetary and fiscal policy, which the markets don’t expect.” But the sudden hit to family budgets, he notes, is very real.
The Fed’s projections are still incredibly rosy, and the markets expect worse
As late as December of 2021, the Federal Reserve’s Open Market Committee was projecting inflation of just 2.6% for all of 2022. (The Fed’s preferred measure is not the CPI, but the Personal Consumption Expenditure Price Index PCEPI that typically shows slightly lower increases.) In March, the Fed raised its estimate substantially to 4.3%. But the PCEPI’s been running at an annualized rate of 6.7% in January and February, with no signs of slowing. “I think the number could easily exceed 5.5% for the entire year,” says Luther. The Fed’s also raised its predictions for 2023 and 2024, the former from 2.3% in December to 2.7%, estimates that are more reasonable but could still prove overly optimistic.
Still, the Fed’s seems as far behind the curve in forecasting inflation as in fighting it. The central bank’s foresees average annual increases in the PCEPI over the next five years of just 2.48%. To put it mildly, the bond markets disagree. The best gauge of investors’ outlook is the Five Year Treasury Breakeven Rate, representing the the difference between the yield on the 5-year Treasury note and the “real” rate as expressed by the on Treasury Inflation Adjusted Securities, or TIPs. The difference, or expected average yearly inflation over the next half-decade, is the breakeven figure. While the breakeven number is based on the CPI, Luther adjusts it to the comparable PCEPI reading, using the yardstick the Fed favors.
But the five year breakeven rate set by the market is 3.61%. “The bond market’s predicting 1.1 points more inflation per year than the Fed through the spring of 2027,” says Luther. “That’s a big miss on the Fed’s part, including its view that the number will be just 4.3% this year.” Let’s say prices rise 6.5% in 2022, slightly below the PCEPI numbers for January and February. The PCEPI would still need to wax at an average of 3% a year from April of 2023 to April of 2027 to reach an average increase of 3.61%. That’s one point and 50% higher than the norm in the five years before COVID onslaught sent the Fed on its easy money course.
Despite the one-time jump, the markets expect inflation to drop substantially in the years ahead
Of course, what the markets are really predicting tis hat inflation will taper down rapidly from today’s highs over the next couple of years. A 6.5% sprint this year followed by 3% in 2023 means the trajectory should reach the mid-to-low 2%s five years hence. And from there on investors are wagering on even lower numbers. There’s also a Ten Year Treasury Breakeven Rate, and it’s predicting that in the out years, from 2027 to 2032, prices will rise a modest 2% a year, right at the Fed’s target.
That would appear a relatively happy outcome. But keep in mind, once we get to mid-2% inflation in, say, 2024, and drop even lower a few years later, those increases will come on top of the giant one-shot increase from late 2021 through part or even most of next year. As we’ve already seen, the gradual rise in paychecks isn’t matching the spike in prices at the pump and check out counter. Even though inflation will probably retreat to its old levels, the current episode will inflict lasting damage on America’s families.
What if things get worse than even the market’s predicting?
Luther’s best bet is that the market’s are correctly estimating the future course of inflation. “Investors have a strong incentive to get that forecast right, so it’s the most likely outcome,” he says. Nevertheless, he’s concerned that though the Fed’s shifted its outlook from complacency to grave concern since late last year, it hasn’t much hardened its policies, and is still issuing bluebird forecasts. “Consider the sources of inflation,” he says. “The Fed talked a lot about supply chain constraints, and the war in Ukraine lifted commodity prices. But the supply restrictions are already easing. Those factors don’t explain a huge chunk of the inflation we’re experiencing. The main cause is the pandemic relief policies that left gigantic amounts of money sloshing around in the economy.”
Yet, he says, the Fed is jogging, not racing. It’s sticking to a moderate path of gradually raising rates and embracing “quantitative tightening” by shrinking its balance sheet, and hence hopefully shrinking credit. Luther isn’t sure those policies are strong enough to keep inflation from running hot longer than the investors expect, let alone the Fed. “Imagine you’re driving from Florida to Ohio, and you’re in Indiana but still too far away to get to your destination on time,” he says. “That’s not the Fed’s position. It’s more like they’re in Alberta headed for Ohio. And if they go too slowly, it could soon be like they’re in Alaska.”
Luther fears a scenario where the Fed keeps delaying tough action so long that businesses lose faith, and become convinced inflation will remain higher, far longer than the markets are now predicting. That conviction would breed a self-fulfilling outcome where companies build escalating prices into their sales contracts, and their suppliers lift their input prices in response. Then, we could see not just the big one-off almost everyone expects is temporary, but years of outsized increases that grind down the fortunes of America’s families.
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