Inflation: Too Much, Too Little, or Not Much in the Middle?
As the economic recovery has taken hold, thanks to the mass vaccination strategy here in the U.S., a debate has emerged in investment circles regarding inflation. The debate has centered around whether the increase currently seen in overall prices is here to stay or if it is transitory. On balance, history has shown that, as the U.S. economy has come out of recessions, the general cost of goods and services does experience an uptick concurrent with the rise in activity – particularly aggregate demand. This flurry of activity has tended to drive general prices higher and, as the recoveries mature into stronger growth, more goods and services are produced to meet higher demand. Thus, resulting in more stable equilibrium prices than were present at the outset of the recovery.
But how does one measure expected future inflation in the U.S. economy? Our favorite measure is a market-based indicator looking at the difference between various length maturity TIPS (Treasury Inflation Protected Securities) and the nominal Treasury of the same maturity length. This represents the bond market’s expectation of what future inflation will be in five, seven, 10 (and so on) years from now. As you can see in the chart below (from NDR), future inflation expectations are in the 2.2 to 2.5% range. It is interesting to note that inflation expectations since the Great Financial Crisis have largely been below 2% for the last 13 years.
Jerome Jerome the Metronome Says ‘Transitory’
Jerome Powell, the Federal Reserve Chairman, has been consistent in his messaging regarding inflation: it will be transitory and it is the Fed’s intention to let economy run hot until there has been substantial further progress in labor markets. If it turns out that it’s not transitory, and we have a proper bout of inflation, Powell and the Fed say they have the tools to deal with such an issue. To form our own opinion on the matter, we looked at a classic measure called the “output gap” as a way to gauge if the economy is operating at, above or below its potential. As you can see in the chart below, despite the recovery, the economy is still operating below its potential.
Additionally, the unemployment gap remains. Spare capacity in the labor market affects wage growth and, therefore, inflation. NAIRU (Non-Accelerating Inflation Rate of Unemployment) is a way to gauge this excess capacity. First, a quick primer on NAIRU: although it can be defined in different ways, it can be thought of as the unemployment rate associated with “full employment.” A firmer definition for NAIRU is the unemployment rate that is consistent with inflation, converging to the rate of long-term inflation expectations in the economy. As you can see in the chart below, more progress is required in the labor market to close the unemployment gap.
These factors, in our opinion, leads us to land in the “inflation will be transitory” camp. Stay tuned!