Untangling Inflation Worries

Inflation may be mild and falling, but that doesn’t stop anyone from worrying. A new survey by MFS Investment Management, for instance, reports that investors are more concerned about inflation over the next 12 months compared with their financial advisors. Sixty percent of investors surveyed say they’re worried about rising inflation over the next 12 months, according to the MFS Investing Sentiment Survey.
Conversely, only 41% of financial advisors think that rising inflation is a concern for investors in the year ahead.

The disconnect arises amid a backdrop of mild and falling inflation lately. Annual consumer price inflation was 2.9% in February, the Bureau of Labor Statistics reports, down from the low-3% range last year. Ignoring the brief deflation spell during the Great Recession, official measures of inflation are currently near their lowest levels in half a century, and it may be headed lower still, considering the recent decline in the annual pace. But that doesn’t mean it “feels” like inflation is low.

Rising energy prices—gasoline in particular—surely stoke inflation worries even as broad measures of prices remain near historically low levels. The average price for a gallon of gasoline in the U.S. is just under $4, or approaching the all-time high set back in 2008, according to the Energy Information Administration. It’s no surprise that higher fuel costs take a toll on consumer sentiment. “Consumer purchasing power, at least for the next few months, is going to remain pressured by rising gasoline prices,” Sam Bullard, a senior economist at Well Fargo Securities, told Reuters recently.
But there’s a risk of letting commodities prices—energy prices in particular—dictate your worldview on the inflation outlook. Previous surges in energy prices have accompanied concerns that inflation was poised to spiral upward, but the fears were premature. The lesson is that commodities prices are volatile, but they tend to be a wash eventually. Perhaps it’s different this time and energy prices will remain permanently elevated. Even that wouldn’t spell disaster for inflation if prices stabilized at higher levels. But economic logic can be in short supply at a time when the crowd is forking over more money at the pump. Nonetheless, it’s important to keep in mind that a fair amount of the current rise in energy prices is linked to the Iranian crisis. When and if that crisis blows over, oil prices could drop sharply.
Meanwhile, with energy prices on the march, inflation anxiety is climbing again. Do those fears amount to another case of overreaction? For some perspective, consider that the Cleveland Fed’s 10-year estimate of inflation was 1.38% last month, the lowest in a generation. Good news? Inflation hawks might think so, but there may be complicating factors, particularly if inflation expectations continue falling in the current economic climate. The new abnormal, as I like to call it, is still in force, courtesy of the blowback from the Great Recession–a blowback that continues to define the relationship between inflation expectations and growth. The two halves of this coin remain tightly bound these days. That’s abnormal, and not widely understood, but for the moment it’s an abnormal relationship that rolls on.
Exhibit A is the tight positive correlation between the stock market and inflation expectations, as defined in the yield spread for the nominal less inflation-indexed 10-year Treasuries. The message here is that a sustained drop in inflation levels at this stage may be a sign of new economic troubles. In other words, be careful what you wish for, at least in the short run.

Nonetheless, populist commentary resonates. Columnist Amity Shlaes, for instance, recently argued that inflation threatens to “capsize” the U.S. But that view looks misguided, or at least premature as long as the new abnormal prevails.
One day inflation will be a clear and present danger for the economy. When that day comes, will the inflation threat suddenly spin out of control? Not necessarily. If Milton Friedman was correct, inflation as a long-term proposition remains under the control of the central bank’s monetary policy. We can debate if the Fed will do the right thing and manage the transition prudently. It’s certainly made mistakes in the past–letting inflation out of the bag in the 1970s, to cite the obvious example. But there’s no reason to think that we’re doomed to repeat yesteryear’s mistakes. Assuming, of course, that we can read history accurately and draw the right lessons.