Inflation Expectations versus Reality

Higher inflation expectations have been ramping up for months and are fully mainstream now. You can read about higher inflation everywhere these days, whether it’s higher commodity prices, higher housing prices or comments from companies about raising goods prices because input costs have risen. Additionally, many argue fiscal stimulus in the form of money delivered directly to individuals and businesses coupled with higher debt levels and even higher expected debt levels in the future will almost certainly lead to higher inflation. The truth is nobody knows with certainty what is going to happen. In a typical cyclical recovery, inflation always picks up. I’m not sure we can characterize our current situation as a typical cycle, let alone a typical recovery. We’ve experienced disinflation for many years and maybe that trend is nearing the end of its run or already has.

In a February post, Barry Ritholz made the case why inflation isn’t guaranteed:

“But Inflation is not inevitable. There are numerous countervailing forces that have been at work for much of the past 50 years. The three big Deflation drivers: 1) Technology, which creates massive economies of scale, especially in digital products (e.g., Software); 2) Robotics/Automation, which efficiently create more physical goods at lower prices; and 3) Globalization and Labor Arbitrage, which sends work to lower cost regions, making goods and services less expensive.

Put into this context, Inflation is periodic, driven by specific events; Deflation is consistent, the background state of the modern economy. To fully understand this requires grasping how scarcity and abundance act as the drivers of the price of labor and goods.”

In a White House Briefing post, Jared Bernstein and Ernie Tedeschi demonstrated through various market- and survey-based measures that higher inflation expectations are real, but those expectations are well within historical levels.

I demonstrated something similar in a blog post several weeks ago, using US Treasury breakeven spreads. Again, higher inflation expectations are present, but we don’t have any evidence that inflation levels above historical ranges will materialize. I’m not suggesting that prolonged higher than expected inflation isn’t in the cards. I’m just not ready to fully commit to that reality.

One final point on inflation. Many believe higher wages are an important driver of higher sustainable inflation. In another White House Briefing post, Cecilia Rouse and Martha Gimbel discuss the compositional effects of average wage growth in the US. Specifically, they highlight April 2020 when wage growth accelerated due to lower wage growth employees being out of the workforce and not included in the average. When you remove the lowest contributors to an average from the pool, the average goes up, which is exactly what happened. In the chart below, the authors project the path of wage growth if employment levels were to return to their pre-pandemic levels across all industries, leading to many lower paid employees’ wages returning to the average wage pool. In other words, as the economy reopens and people return to work, we could see lower wage growth.

This projection doesn’t account for any changes in wages. Realistically, the actual path will likely be higher as many employers have raised wages for their lowest paid employees.

When I worked at Merrill Lynch several years ago, the chief economist, David Rosenberg, often sited the 10 Rules of Investing as developed by his mentor, Bob Farrell. Rule #9 states, “When all the experts and forecasts agree – something else is going to happen.” Seeing all the chatter about higher inflation these days makes me think about Rule #9 often. I guess we’ll see what happens.