You may have noticed, when making your routine purchases at the store that your hard-earned pound doesn't get you as much as it used to. It's not your imagination; the data support what we are all experiencing.
As the charts below illustrate, since the credit crisis ended there has been a dramatic increase in the price of commodities. Energy, food, and metals have all shown significant price increases since 2009, and the rate of increase is increasing.
While the commodity price increases have been significant, the increases in the Consumer Price Index and Personal Consumption Expenditures have been less dramatic, but still substantial. The rate of increase in CPI and PCE has been constrained by offsetting declines in other underlying components such as housing.
As the price increases from commodity raw materials begin to work their way through the supply chain, we expect that the increases in CPI will be heightened.
One would assume that these recent dramatic price increases would be a concern for the Bank of England or the Federal Reserve. After all, isn't price stability one of their mandates? But the key to maintaining price stability isn't just observing and controlling current inflation, but rather observing and controlling the expectation of inflation.
The expectation of inflation is what drives our decisions and thoughts about consumption. If everyone believed inflation would be 10% going forward and would remain at that rate for an extended period, then businesses and contractors would begin to put those expectations into their contract negotiations. That 10% expected rate then becomes the new normal, and workers would demand that rate for pay increases. Employers would not view this demand by workers as overly burdensome because they would be able to pass those increases along to customers, since again everyone is expecting that rate of inflation. This expectation of inflation can become a self-fulfilling prophecy and serves to anchor future inflation at the expected rate. As Simon Kwan, vice president of the Federal Reserve Bank of San Francisco, wrote in October 2005:
The Federal Reserve wants to know what people think--specifically, the Fed wants to know what people think the future path of inflation is. One reason is that people's expectations about inflation influence their behaviour in the marketplace, and that, in turn, has consequences for future inflation. Being able to forecast future inflation plays a critical role in the Fed's efforts to meet its mandate of promoting price stability in the US economy.
How Does the Fed Think About Inflation
It is widely believed that one of the metrics most heavily relied upon by the US Fed is the five-year five-year-forward break-even rate. Inflation break-even rates are simply the yield on a Treasury security less the yield on the corresponding Treasury Inflation-Protected Securities. So effectively, if the 10-year Treasury yields 3.00%, and the 10-year TIPS yields 0.70%, then the 10-year inflation break-even is 2.30%. The five-year, five-year-forward break-even rate is calculated from the 10-year break-even rate by removing the compounded effects of the five-year break-even rate, so that we are just left with the last five years of the 10-year break-even rate.
As the preceding chart shows, while there has been some increase in the five-year, five-year-forward break-even rate, the overall rate appears to be well controlled and still easily under 2.75%. While this rate is currently a little over the high end of the believed Fed target inflation rate of 1.50%-2.50%, it shows no signs of losing restraint.
Some could argue that this rate is being held artificially low through the Fed's "quantitative easing II" programme, since the Fed has been purchasing longer-dated Treasuries and forcing down their yields. While QE2 certainly has had some effect on the break-even rate, it is doubtful that it has had a dramatic impact. If large money managers and hedge funds truly believed this rate was wrong, they could short Treasuries and buy TIPS, isolating the inflation expectation and profiting from its increase.
With the belief that inflation expectations are still controlled, the Fed is free to continue its historically low short-term rates in an effort to boost an economy that continues to muddle along after the economic crisis. As long as economic activity is muted and inflation expectations don't increase, we suspect the Fed will most likely keep short-term rates low, even in the face of actual inflation increasing. In effect, the Fed can subsidise an increase in nominal GDP through short-term inflation because the expectation of inflation has not changed.
So remember that the next time you pay an extra £20 to fill up your car. Think to yourself, "This is only happening because I don't expect it to keep happening."
Jim Leonard, CFA, contributed to this text.
Weekly Bond Market Overview
Credit spreads continued to widen last week as weak economic indicators and a choppy equity market took their toll on market sentiment. Not coincidentally, the rapid pace of new issues on the US market slowed dramatically from the frenzied pace of the prior few weeks. The record-breaking issuance had been driven by low interest rates, tight credit spreads, and heightened demand by investors for fixed-income spread products. We believe a significant amount of the expected new issue calendar was drawn forward and new issuance will be subdued over the next few weeks.
The Morningstar Corporate Bond Index widened 5 basis points last week to +146 as credit spreads widened by 7 basis points in the financial sector and 4 four basis points in the industrial sector. Sovereign credit concerns rose, as numerous news stories circulated about how the European Central Bank and German officials are at loggerheads about how to resolve Greece's financial woes. This uncertainty drove credit spreads wider among the European banks, which are most heavily exposed to Greek debt, and the contagion pulled credit spreads wider among US banks as well. In addition, Moody's announced that it was re-evaluating its methodology that takes into account potential government support in its credit rating, possibly leading to an across-the-board rating cut for the largest UK and US banks.
