Friday, November 12, 2021

How long should we expect high inflation?

There was bad news on the inflation front this week, with the CPI rising 6% over a year ago.  We have not seen 6% inflation in 30 years.  This is a worrisome development for those on fixed incomes, as well as for those whose income growth fails to keep pace with inflation.  

The consensus among economists is that the current inflation is a classic case of too much money chasing too few goods.  Compounding the problem is the covid-induced shift in demand from services to goods.  

Economic history suggests one of two alternative scenarios will play out.  One possibility is that the inflation will prove to be temporary, just like it was in the aftermath of World War II.  In that case there was pent-up demand for everything (many goods were rationed during the war) along with the need to shift the economy away from tanks and aircraft carriers toward housing and education.  Option B: a replay of the 1960s and 1970s, when a vicious circle developed with rising prices feeding into higher wages, which in turn increased costs even more requiring even higher prices.  

Jerome Powell, Janet Yellen and other White House and Fed economists say inflation will be temporary.  Companies will need a few more months to ramp up supply, but once that happens we will be down to 2-3% annual rates.  But not everyone is buying this!

Two clues about the future direction of inflation can be found in the bond market.  First look at the actual yields for five-year and ten-year bonds, which are 3.1% and 2.7%.  Interest rates adjust upward in response to expected inflation, so these rates indicate that the bond market does not expect inflation above 3% over the next five years.  

The second clue: the Treasury sells two types of bonds: those with a fixed yield and those where the yield is indexed for inflation.  Adjusting for maturity, a comparison of the yields tells us what financial markets expect.  So take a look at this chart from the St Louis Fed.  At the beginning of the year, the yields implied an expected inflation rate of 2%.  From March through September, the expected inflation rate increased to 2.5%.  Now it is up to 3%.  

My advice: keep an eye on the bond markets in the months ahead.  


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