Monday, May 9, 2016
Inflation pictures all point in same direction
Inflation expectations are higher across a number of measures. The 5yr/5yr forward inflation rates have shown the biggest increases in three years. The break-even inflation rate has increased 50% this year. The University of Michigan inflation expectations are rising and have been consistently above 2.5%, and the change in CPI year over year has been the greatest in years over the last six months. Granted the inflation expectations have been coming off lows, but the upward trend has been clear. Nevertheless, longer-term rates have not fully incorporated these changes.
Investors will face three questions over the next three months. One, how will these changes in expectations be embedded in longer-term rates? Two, how will the data-dependent Fed react to these numbers if they increase further or just stabilize? Three, what is the implicit trade-off between growth and inflation that markets participants are using and that actually exists? Of the three questions, the third may be the most important for investors since we are seeing weaker growth numbers globally.