Managing Inflation Expectations: 21 May 2021

Long ago and far away, economists thought they understood the relationship between unemployment and inflation. The prevailing wisdom back in the day: higher (lower) inflation aligned with lower (higher) unemployment. Believing in this relationship appeared to be reasonable for the 1960s. But then something happened to shatter this conviction: the 1970s.

The Phillips curve, as the relationship was called, seemed to work just fine as the 1960s came to a close. In fact, the connection seemed almost too good to be true. As it turned out, it was.

Milton Friedman famously saw the writing on the wall in a 1968 speech that effectively warned that while monetary policy could be effective for some objectives, managing the relationship between inflation and unemployment isn’t one of them.

The rest, as they say, is history and economists long ago gave up the ghost for thinking that central banks can raise inflation as a tool to lower unemployment. That past several decades make this blatantly clear. On the eve of the pandemic in February 2020, for example, US unemployment fell to 3.5%, a 50-year low while inflation remain muted, at roughly 2%, more or less where it had been a decade earlier.

The Phillips curve has long been dead as a macroeconomic framework, but it’s still not obvious what’s replaced it. Yes, there are many would-be modeling heirs to the throne, but we live in a world of countless princes and no king. Instead, thinking about inflation has become a quasi-religion, where advocates of one sect or another cherry pick data and economic narratives to promote a particular macro cause celebre.

Where does that leave us in the current environment? In a precarious state. What to do? Watch the data. We may be cut loose from a robust inflation model, but the truth will out via the numbers. The drawback, unfortunately, is that the truth by way of empirical econometrics arrives one data point at a time.

Alas, beggars can’t be choosy and so launches this periodic review of where we stand on the US inflation front. For those who haven’t been watching this sport, one team insists that we are on the threshold of a long run of higher inflation spawned by the usual suspects: government spending via monetary and fiscal channels. Skeptics rightly point out that we’ve been here before. To which the inflationistas reply, yes, but it’s bigger this time.

True, but it was bigger the last time, and the time before that and still inflation remained contained and disinflationary forces intact. There are limits to everything, but deciding if we’re at the limit (or not) reverts back to one’s macro religion (and perhaps a bit of political bias).

In any case, that debate will be formally banished from these periodic updates. Instead, we’ll stick to the numbers, starting with a comparison of the Treasury market’s implied inflation forecast (via the yield spread on 5-year nominal less inflation-indexed Treasuries) vs. the annual pace of the core Consumer Price Index. At the moment, core CPI has surged to 3%, the highest since the mid-1990s. Notably, the Treasury market’s inflation forecast has been anticipating the bounce.

The question is whether the market will continue to raise its inflation outlook? There’s some doubt about what happens next as the 5-year breakeven inflation outlook has been treading water in recent weeks in the 2.6%-2.7% range.

The benchmark 10-year rate is also in a holding pattern lately, suggesting that the crowd is reassessing inflation expectations.

The main event for the next hard-data update: the May numbers for the Consumer Price Index. Using a combination forecast based on eight models, here’s my baseline for expectations: a slight pullback in core CPI for the year-over-year trend through May, based on the point forecast.

Combination forecasts are relatively reliable, but in the current climate the potential for errors is higher than usual, perhaps much higher, and so caveat emptor applies (still). In any case, as new data becomes available ahead of the next CPI report, this forecast will adjust.

Note, too, that the prediction interval for the core CPI trend in May allows for another rise in the trend and so it’s too soon to assume that inflation will be transitory. Then again, ruling out the possibility isn’t beyond the pale either.

But let’s be fair: it’s still early in the game and more data is needed. We’ll keep you posted.

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By James Picerno

2 thoughts on “Managing Inflation Expectations: 21 May 2021

  1. bill dietrich

    Another view:
    James Pethokoukis interviews Charles Goodhart, and Manoj Pradhan.

    What is the current economic consensus on inflation? Why have we had low inflation over the past few decades?
    Goodhart: People generally assume that the low, steady inflation that started in the 1990s is due to better monetary policy and the central bank’s ability to keep inflation down. We disagree.
    Pradhan: Central banks have picked up so much credibility because there’s debate that the Phillips Curve is dead and, as a result, central banks only have to worry about growth, as opposed to inflation. It makes their job relatively easy: If growth goes down, you cut rates. And if growth looks like it’s overheating, you raise rates to slow things down. But we argue that it’s China that put the Phillips Curve in a coma — and that the pandemic and demography are going to revive it.
    China was a massive disinflationary force because it allowed the US and other advanced economies to focus on consumption which, while keeping average global composition of growth pretty sound, really only resulted in investment in China. Also, the West was able to harness China’s technology revolution and well-trained and low-cost workforce. This all worked against what you would see in the Phillips Curve.
    Goodhart: At the same time, there was a huge influx of female workers and Baby Boomers into the workforce, which shocked the sector and led to weak bargaining power and lower inflation on wages and prices.
    Pradhan: Unfortunately, the central bank’s models didn’t catch these strong inflationary forces lurking in the background and instead attributed low inflation to their inflation-targeting regimes.

  2. Pierre Y. P. Chu

    Please read the work by Richard Werner,, that argues for the theory of credit. Money as the liabilities of banks is the wrong place to look; the correct place to look is the assets of the banks–their loans. Loans can be used to purchase existing stocks or real estate assets (not related to nominal GDP) or otherwise (related to GDP). Since the 1990s, the FED released so much money but caused no GDP inflation because credits were used for non-nominal GDP-related purposes. We saw skyrocketing asset prices but little GDP inflation as a result. It is very odd that the FED did not realize that, otherwise it would not have been using GDP inflation (or CPI) being greater than 2% as its “growth target.” Such a target would have been self-defeating, because the FED fails to understand that it is only the portion of money (credit) that is used for GDP transactions will affect nominal GDP.

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