Expert Commentary

Temporary Inflation (Perhaps, but is it Deflation next?)

This oft-watched indicator does not tell us everything about the outlook.

Consumer price inflation expectations are hard to gauge. One way is to use so-called breakeven rates embedded in the pricing of government bonds that are protected against inflation, such as Treasury Inflation Protected Securities (or TIPS). Purists are critical because TIPS contain various elements to their pricing, and so the expected inflation rate that drops out is bastardized somewhat. Nevertheless, breakeven rates can provide reasonable indications of expected consumer price inflation and the fact that there are different tenors is useful too.

The chart below shows the 10-year TIPS breakeven rate minus the 5-year TIPS breakeven rate. In other words, it is showing the difference between market expectations of average inflation over the next 10-years as opposed to over the next 5-years. When the line is above zero, it means that average consumer price inflation is expected to be higher over the next 10 years, than over the next 5 years. When it is below zero, the average inflation over the next 10 years is expected to be lower than over the next 5 years.

Thus, as we can see, the fact that the chart is currently below zero means that the market is expecting longer-term average inflation to be lower than shorter-term average inflation. Many people are taking this indicator as proof that the market is expecting the current blip up in consumer price inflation to be temporary, as the Fed believes also.

Well, yes, it could, but we must be careful.

Look back at the big spike in this chart at the end of 2008. On the face of it, at that point longer-term inflation was expected to be much higher than shorter-term inflation. But using the breakeven curve alone does not give us the full story because what this chart does not reveal is that at the end of 2008, consumer price inflation expectations were collapsing, with the 5-year breakeven rate going to minus 2.24% (i.e., expected deflation) and the 10-year breakeven rate hovering just above 0%. When this breakeven curve chart is above zero, therefore, it won't necessarily mean that longer-term inflation is expected to be in high positive territory. Actually, it could just as easily mean that deflation is expected in the shorter-term.

So, whilst the breakeven curve can give us a useful snapshot of relativity, it doesn't tell us about the nominal direction of inflation expectations. For that, we must look at the breakeven rates alone, and both the 5-year and 10-year are lower now from their May highs.

210723 - MG