Is Inflation on Our Doorstep?

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Inflation, and perhaps more specifically, inflation expectations, sit at the core of our financial markets. Like the sun’s rays, they radiate out influence across the rest of the financial universe.

Fears of deflation have prompted central banks around the world to employ the easiest monetary policies the global economy has ever seen. In the recent past, nearly every central banks’ attempt to tighten conditions has been thwarted by the prospect of disinflation or downright deflation.

For investors, choosing between the inflation camp and the deflation camp is one of the most critical and fundamental decisions that must be made, because it dictates what asset classes to focus on. If you believe deflation is ahead, you’re likely to stay away from things like stocks, gold, and real estate, favoring cash and perhaps items such as bonds, whose prices move higher when interest rates fall.

On the other hand, if you’re in the inflation camp, cash is your worst enemy, and bonds can appear less favorable as rising interest rates may decrease the value of outstanding bonds. Instead, you would prefer items like stocks, gold, and real estate, which are historically good inflation hedges (stocks being the best).

[Listen to: Jason Goepfert: Most Sentiment Measures Show Investors All In]

Inflation and Inflation expectations drive asset prices because they influence how valuable investors believe a dollar is today, versus sometime in the future. They are also a main driver of central bank monetary policy, which exerts a large influence on asset prices in its own right.

This all begs the question, where can we look for indications of upcoming inflation?

Due to the lagging nature of the CPI and PCE reports, they often don’t present the best forward-looking measure of inflation. Like the GDP, they are much better at telling us what has happened rather than what will happen. For example, today we found out that for the month of April, headline CPI edged up 0.1%, but on an annual basis, prices have fallen 0.2% over the past year (chart below).

us inflation rate

Excluding food and particularly energy, we see that core CPI for April maintained its trajectory, up 0.3% for the month and up 1.8% on an annual basis.

us core inflation rate

Janet Yellen spoke last week in Providence, Rhode Island, and reiterated her belief that, “ … it will be appropriate at some point this year to take the initial step to raise the federal-funds rate target and begin the process of normalizing monetary policy.” She emphasized her inclination to move slowly, a characteristic absent in prior rate hike cycles as the central bank chased down above-target inflation.

The path of rate increases, and also the path of the bellwether 10-year Treasury yield, depend heavily on inflation expectations. But since the CPI and PCE are both backwards looking, where can we go for indications of future inflation?

[Read: Sentiment Shift on US Inflation Expectations]

One place we can look for real-time market based inflation expectations is the 5-Year Forward Inflation Expectation Rate, seen in the chart below. This metric looks at spreads between nominal and inflation adjusted Treasury securities.

The chart below also includes monthly data on the 10-Year Treasury yield in red. It hasn’t always been the case, but since about July 2014, the 10-Year yield has been closely tracking the 5-Year Forward Inflation Expectation Rate.

5 year inflation expectation rate

Inflation expectations rose during the month of April, and we saw a similar rise in the 10-year Treasury yield, which has recently stalled, also indicative of the move seen in the chart above.

Based on this data, global investors in aggregate are currently positioning themselves for roughly 2% inflation.

Another place I used to monitor for real-time inflation was discussed in this article, called the Billion Prices Project. This effort, founded by two MIT economists, is geared at using technology and real-time tracking methods to gauge price level fluctuations. Based on the idea that online prices can be changed (and analyzed) much more easily than in-store prices, and there is no lag from having to wait for government entities to compile and release their “official” reports, the BPP (aka. PriceStats Inflation Series) has been able to predict changes in inflation statistics such as the CPI and PCE.

[Don't Miss: MIT’s Roberto Rigobon on the True Rate of Inflation]

The benefit is apparent when you consider that this project, which partnered with State Street, now forces you to pay for access to the most recent data. Non-members have access to data with a two-month lag. We are contemplating subscribing to this data because it’s slowly being adopted as a reliable leading indicator of upcoming changes in the CPI and PCE. A chart of the PriceStats Inflation Series and the corresponding CPI is shown below.

state street pricestats inflation series us

The preceding content was an excerpt from Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.

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About Matthew Kerkhoff