Analysts, it seems, are indefatigable on the subject of inflation expectations these days.
Not that we blame them — we’ve contributed to the cacophony of opinions. And since it’s inflation week here in the US, culminating tomorrow morning with the March CPI numbers, we’ll pass along two more notes on the subject from earlier today.
First up is a handy explainer from Credit Suisse that runs through the various ways to measure these expectations and explains the limitations of each — along with the trickiness of defining the concept itself.
Since we prefer looking at the market-based approaches to the survey-based measures (though both have limitations), we’ll excerpt from that part of the note, and we’ve also posted the full version in the usual place:
Even if we abstract from the existence of an inflation risk component, the drawbacks to using breakeven rates as measures of inflation expectations are well-documented. They include liquidity risk premiums, indexation lags, and issues related to the taxation of earnings from these investments.
That said, it is hard to argue that inflation expectations, as derived from TIPS and nominal Treasury yields, have been stable. The jump in short-term breakeven rates can be dismissed as transitory expectations about commodity prices, such as those for oil. At the time of the March 15 FOMC meeting, 10- and 30-year breakeven rates were nearly identical to those observed upon the announcement of QE2 (on November 3). But they have since climbed some 0.20 percentage point higher. This hardly qualifies as inflation expectations becoming “unanchored,” but it’s worth keeping an eye on.
Next are a few thoughts from Deutsche Bank, which criticises the Fed doves’ argument that inflation gains from commodity price increases are transitory.
We’ve broken up the note to make it a bit more read-friendly:
We believe a couple of points are worth making.
One, inflation expectations are set according to trends in the headline CPI, not the core. This is why consumer price expectations are rising appreciably. For example, the University of Michigan’s median 5-year expected inflation rate jumped 0.3% in March to 3.2%, the highest reading since May-June 2008. We get preliminary data this morning for April, and we think we could see another such jump, thereby taking inflation expectations up to 3.5%. This would be the highest reading since April 1995. In the process, it would make it much tougher for the Fed to credibly argue that inflation expectations are stable.
Two, we do not believe that food & energy price gains are transitory. In fact, when we look over a several year period, we find that food and energy prices almost always rise—they only tend to fall in recessions; indeed, the last time that the combined food & energy components in the CPI registered a three-year decline was June 1988 when they fell at an annualized 0.3% over the preceding 36 months. Over the last three years, food & energy prices are up 1.9%, but over the past year, they are up 5.9%. We doubt this trend will subside in the face of negative real interest rates and a sharply falling trade-weighted dollar.
DB also assesses this morning’s producer price numbers and forecasts an above-consensus reading for tomorrow’s CPI:
Both headline and core readings in the PPI continue to accelerate. Over the last three months, the headline PPI is up 13.0%, and the core PPI is up 4.2%. These are the fastest gains since mid-2008; but the economy was in recession then. Today, the economy is growing—albeit modestly—making it more likely that price increases are passed through to consumers.
We expect more evidence of this in today’s CPI report, where we forecast a 0.4% increase in headline CPI and a 0.2% increase in the core. However, we are worried we could see a 0.3% increase in the core, because owners’ equivalent rent (which is about 30% of the core) and rent of primary residence (which is worth another 10% of the core) could both surprise to the upside. Based on anecdotal reports, the national rental vacancy rate fell further in Q1, which should push OER higher than the 0.1% readings we have seen for the last six months. Moreover, since 2008 the consensus forecast has missed on its estimate of the core CPI over 68% of the time. Given the current backdrop, it seems to us that if there is another forecast miss, it will be to the upside.
Tune in tomorrow morning.
Related links:
Deflated inflation expectations – FT Alphaville
The qualifier in Yellen’s speech – FT Alphaville