Inflation Is Not Expected to Go Higher Anytime Soon

September 3, 2020

Source: Bloomberg Source: Bloomberg

Unprecedented policy responses, such as the expanded Federal Reserve (Fed) bond purchase activity (quantitative easing) and record amounts of fiscal stimulus, were successful in preventing an economic catastrophe as a result of the coronavirus pandemic.

These unprecedented measures of accommodation have created two camps predicting the path of inflation in the post-pandemic economy. One camp expects runaway inflation due to this enormous cash injection into the economy. History proves that central banks are rarely able to reduce their balance sheet after periods of great expansion. Therefore, excessive money creates a bubble and it will burst, followed by more capital injection and so forth. More money with fewer products and services inevitably creates inflation.

The other camp on inflation takes its cues from the recent experience of the European and Japanese economies. They are experiencing long-term deflation more than two decades after receiving consistent capital injections as their economies lost steam. The crowding-out effect is the best theory to explain this scenario. The risk-free security becomes king — even its interest rate goes negative — because deflation expectations make economic agents refrain from consumption and investment. Hence the risk premium of the economy decreases, and more capital injection is invested in either domestic risk-free securities or overseas securities that have an attractive risk-return profile.

In this week’s chart, we investigate what the financial market has historically expected for the inflation rate path in the short term. In a similar approach to my previous “Chart of the Week” post, the trend of the 10-year breakeven rate represents the market expectation of annualized inflation in the next 10 years. The forward curve starting from each month shows where the market expects inflation to go (red line) and the actual path (black line). In times of crises in 2008 and March 2020, we see dips in inflation but very steep slopes in the forward curve, which means that the market expects inflation to recover. On the other hand, when the forward curve is flat, inflation is expected to remain low.

Key Takeaway

From an investment perspective, although the impact of a macro event like the coronavirus pandemic is extremely difficult to predict, the capital markets today are not pricing inflation to go higher any time soon, as the most recent forward curve is very flat. Therefore, market pricing supports the deflationary camp for now. This is in line with the Fed’s policy change allowing inflation to overshoot its 2% target, which was announced by Fed Chair Jerome Powell during his recent Jackson Hole speech.

In contrast to the benefit of long-term Treasury bonds expressed in my previous “Chart of the Week” post, the benefit of holding Treasury Inflation-Protected Securities (TIPS) increases from an inflation rate rising. With the forward curve as our guide, the short-term holding of TIPS does not seem to be beneficial for now.

Tags: Inflation | Federal Reserve | Treasury Inflation Protected Securities (TIPS) | Central banks

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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.  This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

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