Fed's estimate of current, forward inflation < 4.5%, roughly

Investment Analysis Clubs Macro Economic Trends and Risks
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When measuring inflation, I’m most interested in understanding current and near-term forward inflation. Year-over-year inflation numbers look back over the last 12 months and are very lagging indicators and thus are less relevant in my mind when thinking about where asset markets might be going in the near future.

In his press conference after the September FOMC meeting, Powell gave some hints as to the FOMC’s current and forward view of inflation.

Powell said (p. 10, link below):

“And you see this I think in the Committee forecast, you want to be at a place where real rates are positive across the entire yield curve. And I think that would be the case if you look at the numbers that we’re writing down and think about, you measure those against some sort of forward-looking assessment of inflation, inflation expectations, I think you would see at that time, you’d see positive real rates across the, across the yield curve…”

This means, approximately, that the FOMC’s forward estimates of inflation should be less than their forward estimates of the Fed funds rate. At the end of 2022, the median Fed funds rate forecast from the FOMC committee is 4.4%. At the end of 2023, the median Fed funds rate forecast from the FOMC committee is 4.6%.

So, their estimate of inflation by the end of 2022 and 2023 is most likely below about 4.5% plus some spread (because many borrowers do not borrow at the Fed Funds rate, but borrow at some spread above that rate, such as typical corporate bond yields, or mortgage yields - of course the US Treasury might borrow near the Fed Funds rate and as a major borrower should be included when thinking about the borrower mix). But the Fed’s aim is for policy to be well into restrictive territory by the time rates reach the forecasted future Fed funds rates of about 4.5%, so ballparking forward inflation below 4.5% is probably not a terrible back-of-the-envelope estimate.

Further, Powell said (p. 7):

“…we’ve just moved I think probably into the very lowest level of what might be restrictive…”

I found this statement interesting for what it might reveal about the Fed’s estimate of current inflation.

The Fed is saying that they estimate that the current Fed funds rate (3%-3.25%) is at the edge of being restrictive and should begin to reduce inflation. Near the time of the FOMC meeting, the 2-year Treasury yield was about 4% and the 2-year investment grade corporate bond yield was about 5%. So, the Fed’s estimate of current inflation is most likely below the 4% to 5% range.

Powell Press Conference Transcript Sep 2022
Bond Yields

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for what it is worth if I am reading this right hand column figure correctly inflation decelerated by 9.2% in August. The pace of the deceleration is going to increase. This makes the y/y inflation rate on a chart look more interesting.

Inflation is not a major issue right now looking at the m/m rates. It is decelerating as well. Probably going negative. Negative is an odd way of seeing it for measuring it right now.

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I’ve always had a tough time understanding forward inflation. Let’s say “the market”, because it includes “everyone” is most accurate. Right now, “the market” has the 5-year treasure note trading at about 2.25% over the 5-year TIPS. I think that means that the market expects 2.25% average inflation over 5 years. If we have a year or a year and a half of 4 to 5%, that means that the next 3 1/2 to 4 years needs to have inflation under 2% for those bond prices to be rational.

(I think this is correct, but if not, please explain the correct logic to us)

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Mark,

You are seeing a larger problem with the entire treasuries market. During this period of the cycle treasures will often ride behind the inflationary forces in the economy. Meaning they are to a greater extent offering negative yields. Not entirely of course but at times. That is highlighted right now. There will also be longer stretches of lower inflation but with lower yields offering very unnoteworthy returns.

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I don’t think you understood the point. The question is essentially - why would a 5-year Note trade at a different net yield than a 5-year TIPS? Same credit quality, almost same characteristics (when adjust of course), same issues, same, same, same …

Obviously the answer can only be that people (“the market”) have a different expectation. But I am searching for insight of possible other factors.

Also I don’t think these 5-year TIPS can have negative real yields. I think they are now CPI+1.78% or so. So their real yield will be 1.78% (pre tax).

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I understand the question. But you just came up with a 1.78% real yield. My final point was something along the lines of it not being worthwhile.

The finer points of the conversation cant change that. No amount of information can change that.

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I believe you have this correct. Treasury and TIPS markets are implying about 2% inflation over the next 5 years based on breakeven rates (your 2.25% value), see 5-Year Breakeven Inflation Rate (T5YIE) | FRED | St. Louis Fed. Interestingly, the 5 year breakeven recently peaked around 3.5% back in March.

I guess the market does not believe we will have 4% to 5% inflation for a year or two. And based on what Powell says above in this thread, I don’t think the FOMC believes inflation will be at 4% to 5% for a year or two (Powell said that they believe the Fed funds rate currently is at the lower end of restrictive).

Of course the market and the Fed could be wrong. A supply shock or two could easily put further upward pressure on prices.

If both the market and the Fed are wrong, then TIPS are underpriced relative to Treasurys. But this doesn’t mean TIPS are a good buy, because they still have interest rate risk. If interest rates continue to rise as part of the fight against inflation, then even though TIPS have inflation protection, they are still sensitive to interest rate changes and could decline because of this effect.

Ironically, with inflation high, TIPS may not be a great purchase because of the potential for more interest rate increases (this kind of makes me wonder what TIPS are good for).

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“Also I don’t think these 5-year TIPS can have negative real yields. I think they are now CPI+1.78% or so. So their real yield will be 1.78% (pre tax).”

METARs, several of you simply don’t have the data on TIPS or understand how inflation expectations work.

The Fed bases its inflation expectations on the bond market. Note that the 10-year nominal TIPS yield was negative between January 2020 and May 2022. Since inflation was running between 1.5% and 2% during that time, the real yield of the TIPS, like the Treasury, was under 1%.

The 5-Year, 5-Year Forward Inflation Expectation Rate is the difference between the 5 year Treasury and the 5 year TIPS. It is currently 2.18%. An investor who believes that inflation will exceed this over the next 5 years should buy TIPS, not Treasuries.

The Fed didn’t say that they estimate the forward inflation rate will be higher. They said that they want their tightening policies to bring real inflation down to that level. They predicted a fed funds rate of perhaps up to 4.5% might be needed to do that but there is high uncertainty since they are flying by the seat of their pants and readjusting as new data comes out. They want PCE inflation to be around 2% for several months to be sure it won’t pop back up as it did in the 1970s.

Wendy

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The dance by the FED is very highly choreographed with fiscal policy. Must add a reasonable fiscal policy or there is a huge outcry like we saw recently in the UK with the currency and bond market drops.

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hi Wendy

A couple of questions for you

What are you trying to say here? I’m just not following your wording.

Can you share a link or source where Powell or the Fed says this? I didn’t see where anyone gave guidance that is so specific as this.

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"The Federal Open Market Committee’s (FOMC) overarching focus right now is to bring inflation back down to our 2 percent goal. "

“In January 2012, the Federal Reserve announced that it would use the PCE as its primary measure of inflation, preferring it for three primary reasons: The expenditure weights in the PCE can change as people substitute away from some goods and services toward others.”

Wendy

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I am not discussing the fed, I am discussing simple math. The 5-year TIPS was TRADING at 1.78%. That means it will yield CPI + 1.78% for a real yield of 1.78%. The 5-year Treasury note was TRADING at 2.25% + 1.78%. That implies average inflation of 2.25% over the 5 year period.

If you believe average inflation will be higher than 2.25%, then you buy the TIPS and come out ahead. If you believe average inflation over the 5 years will be lower than 2.25%, then you buy the notes and come out ahead. Now, since the treasury market is VAST, and there are people, MANY people, on both sides of the trade, then inflation REALLY is expected to be 2.25% over the 5 year period. That almost surely means that the inflation will be entirely front loaded (22/23/24 maybe) followed by near zero or even negative inflation (“deflation”) in 24 maybe/25/26/27 through maturity. Can it be any other way? If we have 2% in 22 (oct-dec),5% in 23, 4% in 24, then 25/26/27 (through Sep) has to total about 1-2% to make the average come out to about 2.25% over the 5 year period.

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Yes, that seems to be what “many people” expect. Many people can be wrong.

Many people were wrong when they thought that Enron was a great investment. Many people were wrong when they thought slicing and dicing sub-prime mortgages could make them not sub-prime. Many people were wrong when they thought tulip bulbs were incredibly valuable.

And I suspect many people are wrong in their expectations of inflation over the next 5 years.

–Peter

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It is possible that they are wrong, and I tend to agree. But because “many” in this case includes the aggregate of ALL bond traders, I hesitate to act (in any big way) on my above agreement.

I do have to say, some TIPS are looking mighty fine recently. Especially the 5-year TIPS. TIPS differ from I-bonds in that TIPS can lose principal value during deflation whereas I-bonds can’t. However, regardless of what the fed does over the next 5 years, I don’t see any meaningful deflation until after that period.

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It may be worth remembering how long it took Volker to get on top of inflation. He was appointed in mid 1979, and inflation didn’t turn the corner until 1981. By that time Jimmy Carter was out of a job and the country was in recession. But even 1981 puts a happy face on it, because inflation didn’t just come crashing down, it took until 1983 for it to get back to 4%, and all the while that was happening Reagan was underwater in his approval rating.

Suddenly the clouds parted, inflation was tamed, and Reagan’s huge deficit spending primed the pump and the economy took off. (It didn’t hurt that oil prices also fell by 2/3 as OPEC began to squabble among themselves and cheating was widespread.)

So I’m guessing that “5 years” is a pretty good window for us to have no idea what is going to happen. Actually “after 5 years” is also good.

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I bought some in today’s auction. Sold at a discount to par, yield 1.72% with the principal adjusted for inflation. Considering that even the 10 year Treasury had a negative real yield for much of the past 5 years I think that this is a safe and low-risk investment.

Can be bought from Treasury Direct or via Fidelity, which doesn’t charge for orders placed for Treasury auctions.
Wendy

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google result

In 1947, inflation jumped to over 20 percent , as shown in Figure 1. According to the Bureau of Labor Statistics (BLS), the rapid post-war inflationary episode was caused by the elimination of price controls, supply shortages, and pent-up demand. The Korean War started in June 1950 and hostilities ceased in July 1953.

Another google result 1948 inflation tipped 8%.

Historical Parallels to Today’s Inflationary Episode - CEA - The White House.

Note if all I needed from you were likes you would not get this information. I’d be blabbering about the good old days when I was CEO…yada yada yada…

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Much the same conditions that exist after the covid impact on the economy waned.

Steve

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Steve,

In a word Yes

The big difference between 20% and 10% is currently we were practicing counter cyclical econ to ward off a great depression 2001 to 2021.

I think from here we go into a straight forward demand side period with the passing of the IRA.

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Those 5-year TIPS that I mentioned on 20-Oct were yielding 1.93% … they’re not as sweet today … currently trading at 1.66%.

My TreasuryDirect account is locked out and I’ve tried calling them for weeks and weeks to no avail. Nobody ever picks up the phone. I’m nearly ready to just open a new TD account or trade via broker instead.