MUNIX COMMENTARY – WEEK OF 19 April
How do we measure inflation?
Many investors are worried that inflation must pick up at some point in the future. After all, central banks around the world have released a flood of liquidity into the real economy and financial markets. UK money supply, for example, is up about 14% from a year ago, on the broadest M4 measure, well ahead of nominal GDP growth. Although wages are understandably restrained, there are various signs of pressures along the supply chain, whether Chinese export prices or raw material costs or the shortages of key components such as computer chips. However, central banks continue to insist that inflation is under control – and that after a short-term bounce this summer, largely due to what happened a year ago, then inflation will be well behaved for some time to come.
Who is right? At face value, the Bank of England has little to worry about – after all headline inflation on the CPI measure only reached 0.7% pa last month. Of course, what matters for central bank policy making is what inflation will be in two years’ time. One way of examining this issue, therefore, is not to look at today’s inflation rate but analyse forecasts for tomorrow. These matter considerably; central banks are making much of the fact that inflation expectations are well anchored.
There are two usual methods of looking at future inflation, using consumer surveys and financial markets. Sadly neither is perfect. The former should be more useful in theory – after all most central banks have a target of controlling price movements as they relate to consumers in their shopping, rather than any other measure of inflation in an economy – house prices, share prices and so forth. A standard example in the UK is the Citigroup/You Gov monthly survey, which in March reported expectations for inflation one year ahead running at 2.7%. This might seem higher than the MPC’s target, but this, and indeed other such surveys, regularly run above the Bank’s objective. In the USA, for example, the Michigan consumer survey showed an extremely sharp jump in the 1-year ahead inflation expectation from 3.1% to 3.7%, which would be the highest reading seen since March 2012.
There are a variety of reasons for this situation. One is that households pay rather more attention to items which they purchase frequently, such as food and petrol, than items they buy occasionally, say TVs, or ones where quality changes can be considerable over time, say smartphones. Hence, the in jump in US inflation expectations neatly matches the massive increase in gasoline prices from a year ago – a time when the global oil price temporarily fell into negative figures. Putting aside such short-term considerations, the Bank of England can point to its own survey on inflation expectations 2-3 years ahead which – it just so happens – are very much in line with the official target.
For all these reasons, central banks also pay attention to what inflation is priced into the bond markets. In simple terms, the gap between real and nominal bond yields is a measure of future inflation – putting to one side of course the thorny issue that central banks are buying massive amounts of such bonds so it is hardly a ‘free’ market, or that regulation, say for UK pension schemes, has long encouraged a significant demand for inflation linked debt well in excess of supply. Another technical measure is using the swaps market to estimate what inflation might be in 5 years’ time.
At face value, 5 and 10-year inflation measures as priced into today’s markets are not a concern for central banks. In the USA, the figures are about 2.6% and 2.4% respectively, only back in line with the levels seen before the 2008 financial crisis or in 2011-12 before the crisis affecting the EMU. In the UK, the markets are forecasting inflation 2-3 years ahead as high as 3.5%. However, to put this figure into context, all during the period 2010-18 the figure averaged 3.1%, so the deterioration has not been significant. The same situation can be seen in market estimates for inflation 5-10 years ahead.
Should UK investors worry about inflation? Undoubtedly. There are warning signs from such factors as rising commodity prices, pandemic-related disruption to major industries and supply chains, or large (never ending?) stimulus programmes. Indeed, central banks may well start to taper their support for the real economy as vaccination programmes have more of an effect. However, as long as inflation expectations are well anchored, which currently they seem to be, then central banks can be gently reactive rather than aggressively proactive in their decision making.
Andrew Milligan is an independent economist and investment consultant. This note should be considered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making