The latest inflation readings from the US Bureau of Labor Statistics, released August 10, came as a relief to both financial markets and consumers, as they appeared to indicate some cooling off in the recent rapid rise in prices. The 8.5% rise in consumer prices came in below analysts’ expectations, largely as a result of lower energy prices.
This apparent pause in the upward rush of inflation offers a good point from which to consider both public perceptions and market expectations about the future course of inflation in the US economy. Investors will recall that for much of the second half of 2021, the outlook for inflation was variously characterized as “transitory” by the Fed and “worrisome” by many analysts and economists. Media coverage of the question teetered back and forth between the two. And then, early in 2022, with inflation making new highs month after month, the question shifted from “Is inflation going to continue?” to “Is inflation ever going to end?”
It seems, though, that the financial markets may be sending a more encouraging signal. The break-even inflation rate (BEI) offers a metric of what the market is anticipating. Calculated as the difference in yields between nominal bonds and those with inflation protection (particularly Treasury inflation-protected securities, or TIPS), the BEI describes the inflation rate at which investors would be just as comfortable owning bonds with no inflation protection as with owning TIPS.
As the above chart illustrates, from January 2021 to about mid-September, expectations for future inflation, as measured by BEI, remained relatively low and constant. Then, with consistently higher readings in the CPI and PPI, the consensus evidenced a spike in anticipation of future inflation, which peaked at 6.3% in March of this year. Since that time, expectations have somewhat changed course, with the latest readings in BEI suggesting future inflation in the range of 5%. In other words, the collective judgment of the marketplace may be signaling its anticipation of lower inflation in the future.
It’s important to remember that market expectations can change, sometimes rapidly. One need only go back to May 2021, when the one-year BEI was at just under 3%, to realize that changing circumstances can radically alter both investor sentiment and forward pricing in the markets. Market prices rarely move in a straight line, either up or down, so it will be important to continue monitoring the Fed’s progress in tamping down inflation, which would be generally viewed as positive for the markets—and the economy.