The most recent CPI numbers show a decline of 0.8% for the month of April, triggering questions about both a possible deflation and where prices are likely to go in the future. The fact is that no one knows what inflation will do in the short run, and all we have to go on, as yet, is fragmentary evidence that might suggest which of the competing hypotheses is more likely to be correct.
The most recent data, aside from the headline CPI figures and some rough breakdown of components for April, are in the March components that make up the CPI. April data show some key components that have accelerated while others have declined. For example, the following chart from BLS shows the sharp decline in energy prices, while not surprisingly, food has increased significantly.
Food to be eaten at home was up more than was food to be purchased from restaurants; and of that, meats and poultry were up the most, followed by dairy products. All these segments have been negatively impacted by supply chain disruptions, creating shortages in the face of increased demand, in part related to panic hoarding and in part to the fact that more Americans have been eating at home. What is also important is to recognize that the large percentage declines are the year-over-year changes for the monthly data.
Clearly, financial dynamics have changed, and this change affects the ability of models to predict with some degree of accuracy. The monthly data for March, broken down by the Dallas Fed in computing its trimmed mean, show that 72 of the 178 components to the CPI declined a weighted cumulative total for the month of minus 33 basis points from the CPI, while the remaining 106 components added 31 basis point to the index.
Additionally, it is not clear that current events have, as yet, had a significant impact upon expectations. The chart below shows the most recent data from the Atlanta Fed’s May predictions for inflation one year ahead, based upon its survey of businesses, which is at 1.5% and unchanged from the previous month. This figure is somewhat surprising given what we know about unemployment and the virus’s impacts on the real economy
Over the longer term, the story is not much different. Those numbers show a much higher rate of inflation than we are seeing now. Here is another picture of the Atlanta Fed’s inflation expectation 10 years out (which actually isn’t very useful for the short term). This number is consistent with a much higher rate of inflation above the Fed’s target rate, a rate that hasn’t been achieved for the past 10 years or so.
Interestingly, the Atlanta Fed also publishes a set of deflation probabilities that the inflation number will be below a reference point. The following chart shows that the probability that we will experience inflation below what was expected as of April 15, 2019 (which was 2% on a year-over-year basis) has been essentially zero for the entirety of 2020, notwithstanding the pandemic.
Breaking that longer-term forecast down to components related to real return versus inflation compensation, at least for the short term, shows inflation compensation next to zero.
With regard specifically to the issue of TIPS, the Cleveland Fed shows longer-term yields essentially at zero.
The bottom line is that we are looking at inflation at or below 1% for the near term. What should we look for in terms of signals otherwise? We should focus on two dimensions – demand and supply. Supply will likely recover faster than demand will, and that difference will keep inflation pressures dampened. Without excess demand, you can’t bid up prices; and if you try to raise them, people will turn to substitutes.
What does this mean for the term structure? Again, the following chart shows recent data on the term structure from the Cleveland Fed. Short-term for the next three years, we see rates below or possibly at 1%.
The wild card in all this is that we don’t know what the Treasury financing needs will be and how much upward pressure they will put on rates. How much of that will end up on the Fed’s balance sheet, and how much crowding out will this result in? If we get another $3 trillion in government spending, what will this do to rates? And this is in an environment with little or no inflation.
Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
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