Weekly Perspective: Anchors Aweigh, My Boys, Anchors Aweigh! A Look at Inflation Expectations
Inflation may “always and everywhere” be a “monetary phenomenon”, but there is a strong psychological component.
The psychology of inflation is at the root of why the Fed adopted a 2% inflation target.
The origin story of a 2% inflation target starts in New Zealand in the late 1980’s. New Zealand had been experiencing years of double-digit inflation. Food and energy prices were soaring, and wage increases were racing to keep up with rapidly rising costs.
With the research and leadership of some bright thinkers (one was a former kiwi farmer), the Reserve Bank of New Zealand embarked on a new policy experiment. Instead of targeting the money supply to control inflation, like good monetarists would, the central bank stated that it was directly targeting inflation to be 0-2%. It was a bold policy move, but it worked. The explicit target broke the wage-price spiral and brought inflation under control:
“Merely by announcing its goals for inflation, and giving the central bank the independent authority to reach that goal, New Zealand made that result a reality. In negotiations over wages or making plans for price increases, businesses and labor unions across New Zealand started assuming that inflation would indeed be around 2 percent. It thus became self-fulfilling, with wages and prices rising more slowly.” (New York Times article here)
This illuminated that the inflation expectations of consumers and businesses are an important driver of realized inflation in the economy. Inflation is not just a function of too much money chasing too few goods, it also is driven by where consumers and businesses expect inflation to be in the future.
If you expect prices to rise in the future, you may be inclined to buy more today in order to lock in today’s lower price or you may raise prices to offset expected cost increases. This extra buying demand and price hikes today can then make inflation fears self-fulfilling.
The inverse of this is why economists are so afraid of deflation. If you expect prices to go down in the future, you may be in no rush to buy to wait for a lower price. This suppresses near term demand and thus causes prices to fall, which then causes you to wait even longer to buy in anticipation of further price declines. The dreaded deflationary spiral.
So when the Fed assesses the current inflationary environment, where some measures of prices are rising at the fastest pace in 40 years (see inflation data segment below), and calls it “transitory”, the Fed is messaging that it does not expect the near term price increases that consumers and business are experiencing today to meaningfully increase inflation expectations in the future.
This is what the Fed means when it says inflation expectations are “well-anchored”: today’s price increases will not cause consumers and businesses to expect higher prices in the future.
But we are seeing inflation expectations for the future start to move higher. The University of Michigan Consumer Confidence survey posted a surprising decline in April due to rising consumer inflation expectations (82.8 vs. 90 consensus and 88.3 the prior month see Bloomberg article here). Chart 1 shows the jump in the inflation expectations portion of the Consumer Confidence survey. The market based 5-Year, 5-Year Forward Inflation Expectations (market expectations for inflation 10 years in the future) are now at the highest level since 2014 (see Chart 2). Google searches for inflation have sky-rocketed to the highest level since the data started in 2004 (see Chart 3).
The big question is: will the sharp price increases that consumers and businesses are experiencing today (we detail them in this note) cause them to expect higher prices in the future? This spiral higher in future price and cost expectations contributed to inflationary experience of the U.S. in the 1970’s and New Zealand in the 1980’s (and many other examples). Add on top of today’s price hikes, we have a Fed that is saying it will allow inflation to run higher than its 2% target for “some time” to make up for all the time it was below target. Could this possibly remove that dampening mechanism that an explicit, low inflation target has had on inflation expectations in the past.
An aside on that note, it is a peculiarity in hindsight that the Fed adopted its formal 2% target for inflation in 2012, a time when the powerful deflationary forces of deleveraging following the Great Financial Crisis were not at all similar to the New Zealand experience of the 1980s. In fact, following the adoption of the 2% target we can see that the Fed’s own composite measure of inflation expectations took a meaningful step lower (Chart 4).
Back to our regularly scheduled programming answering the “big question”.
First, it is definitely too soon to tell if inflation expectations have made a sticky shift higher. Further, we should not read too much into one month of data, mostly one that was clearly skewed by unique pandemic disruptions.
There are two (resolute) camps of opinions about the future path of inflation.
One camp (and the Fed) says no, inflation will return to normal post these near-term distortions. All of the disinflationary forces of demographics, globalization, technology, and low labor bargaining power remain. These forces will continue to keep a lid on longer term price increases and will make today’s increases in inflation a one-time step-change function higher. Supply chain blockages will eventually clear and the base effects that are pushing numbers higher this year will flip to be tough comparisons in 2021.
The other camp says maybe there is a greater risk of inflation sticking around. This Dallas Fed paper argues that the short term spike in oil prices in the early 1970s, due to the OPEC oil embargo, shifted consumers’ perception of inflation and led to a sustained period of elevated inflation expectations and realized inflation for the remainder of the decade. Non-voting Fed member and frequent policy dissident, Robert Kaplan, identified these rising inflation expectations as a key risk (see Reuters article here).
So again, it is too soon to judge if we have begun to see a de-anchoring of inflation expectations. We have to move through the “base effect” months of easy comparisons, as well as observe how prices react as supply chains start to normalize (whenever that may be). As we move into the back half of 2021 we may begin to be able to judge if inflation expectations are truly “anchors aweigh”.
For now, we expect high inflation readings through the summer months, which likely continues to support Value over Growth and higher long term interest rates. Long-term interest rates did not move much to the upside surprise in last week’s inflation data, because a “big” number was likely already priced in. If upside surprises to inflation continue, this would likely reignite the move higher in long-term yields. We note that the 2 Year yield did not budge last week, indicating that the bond market does not believe the Fed will begin tightening policy anytime soon. In contrast, if inflation readings do remain high, it could also increase chatter about the Fed removing stimulus, which likely increases volatility in equity markets (as seen in last week’s price action). If the US Dollar continues to weaken, this would add fuel to the fire for inflation readings, putting upward pressure on commodity and import prices.
Last Week in Markets and Data
U.S. equity markets declined last week (S&P 500 -1.39%, NASDAQ -2.34%, Dow Jones Industrial -1.14%). The underperformance of Growth vs. Value continues with Growth (-2.21%) and Value (-0.78%), bringing the YTD outperformance of Value to 13%.
From a sector perspective (see Table 2), Technology and Consumer Discretionary were the weakest (one large EV manufacturer was down over -12% on the week), while Materials, Financials, and Staples were the strongest (an interesting combination of leadership given Materials and Financials are very cyclical, while Staples is very defensive).
From a size basis, small caps continue to underperform (Russell 2000 -2.07%). The gap of outperformance of small vs. large has now narrowed to less than 1% after reaching as high as 14% in mid-March. We have noted that small caps became very “overbought” in 1Q21 (by noting the record distance small caps were trading above their long-term trend 200 day moving average). This overbought state was a function of the extreme speculative fervor that had gripped the market in the first couple months of the year.
Speculative Fervor is Taking a Breather
In addition to small caps giving up their outperformance (see Chart 5), there are multiple other signs that some of the speculative froth has been let out of the market.
IPO’s, often some of the riskiest names in the market given they are unproven as public companies and often are less mature or loss-making businesses, have been underperforming in recent weeks. Chart 6 shows the relative performance of IPO’s vs. the market, illustrating that nearly half of the massive IPO outperformance from 2020 has been reversed in 2021. Some companies are choosing to pause their listings for fear of going public with a shaky market backdrop (see Bloomberg article here). Unprofitable tech companies or “innovation” companies are also underperforming sharply (see WSJ article here).
Inflation Surprises to the Upside
The upside surprises to inflation were substantial. Charts 7, 8 and 9 show this data as well.
|CPI YoY||+4.2%||+3.6%||Largest since 2008|
|CPI MoM||+0.8%||+0.2%||Largest since 2009|
|Core CPI||+3.0%||+2.3%||Largest since 2006|
|Core CPI (MoM)||+0.9%||+0.3%||Largest since 1982|
|Import Price Inflation||+0.7%||+0.6%|
Source: Bureau of Labor Statistics, Bloomberg
Note: CPI is Consumer Price Inflation; Core CPI is less food and energy prices, which tend to be more volatile; PPI is Producer Price Inflation; YoY is Year over Year; MoM is Month over Month
There were clearly base effect impacts in this data, but many market commentators noted that the increase in inflation cannot be totally ascribed to base effects. The base effect impact was most notable in areas like the sharp jump in used car prices. Used car prices rose +10% in April, the fastest on record, and contributed to a full one-third of the all-items price increase. Other components that were hit the hardest by the pandemic shutdowns also saw large price increases year over year as the activity normalizes (airfare, hotels, etc.).
Yields Shrug Off Higher Inflation
There were clearly base effect impacts in this data, but many market commentators noted that the increase in inflation cannot be totally ascribed to base effects. The base effect impact was most notable in areas like the sharp jump in used car prices. Used car prices rose +10% in April, the fastest on record, and contributed to a full one-third of the all-items price increase. Other components that were hit the hardest by the pandemic shutdowns also saw large price increases year over year as the activity normalizes (airfare, hotels, etc.). to a steepening of the yield curve, which contributed the outperformance of the Financial sector on the week.
Precious Metals Outperform Industrial Metals
Despite the move higher in interest rates and the stronger dollar on the week, Precious Metals (+0.18%), such as Gold and Silver, were positive on the week. They likely benefitted from investors looking for an inflation hedge (and possibly the rotation out of some crypto currencies). Industrial Metals (-2.6%) were down on the week as key industrial metals experienced sell-offs after huge rallies over the past month. Iron ore was down nearly -10% on Friday after China announced moves to control the surge in prices (see Bloomberg article here).
Table 1: U.S. Equity market Performance
|Index Name||1 Week||YTD||Price|
|Russell 2000 Small Cap||-2.07%||12.65%||$2225|
|S&P 400 Mid Cap||-1.75%||18.00%||$2772|
|Russell 1000 Growth||-2.12%||4.19%||$2529|
|Russell 1000 Value||-0.78%||17.18%||$1581|
|Dow Jones Industrial||-1.14%||12.34%||$34,382|
|Dow Jones Transportation||-0.16%||27.27%||$15,917|
Source: Bloomberg, Fieldpoint Private
Table 2: S&P 500 Sector Performance
|Index Name||1 Week||YTD||Price|
Source: Bloomberg, Fieldpoint Private
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