CONTRIBUTION Where is inflation heading?
'No single measure can truly forecast the future'
Meera Pandit, Global Market Strategist at J.P.Morgan Asset Management / J.P.Morgan Asset Management
By Meera Pandit
One of the most prevalent concerns among investors today is where inflation is heading next. The U.S. Federal Reserve (Fed) watches inflation expectations closely, in part because expectations can be a self-fulfilling prophecy.
Consumer expectations, measured by the University of Michigan Survey of Consumers, tend to be the highest, currently at 2.8 percent. This reflects the pricing pressures consumers face in their daily lives, which may not be fully represented in the Consumer Price Index (CPI) due to its composition.
For example, median existing home prices are up an astonishing 23.6 percent, year-on-year, and median new home prices are up 18.1 percent over the same period, while the equivalent housing component in CPI is up just 2.1 percent. That is because shelter prices are not measured by the costs of actual units sold, but rather what homeowners surveyed think their home would rent for if they rented it out (owners' equivalent rent). Also, the component weights of CPI are revised every two years on a lag, and may not reflect real-time consumption patterns.
Economists, on the other hand, are familiar with the components and complexities of CPI, and can therefore account for them in their forecasts. Professional forecasters, measured by the Federal Reserve Bank of Philadelphia's Survey of Professional Forecasters, anticipate 2.3 percent average CPI over the next 10 years. Forecasters' expectations are remarkably stable compared to consumer or market expectations, as forecasting inflation is notorious challenging, and forecasters anchor expectations with monetary policy. The Fed has a 2 percent inflation target, although would tolerate an overshoot to balance muted inflation over the past several years.
The market, too, heeds monetary policy, but is subject to other market forces as well and is therefore the most volatile of the three. The five-year, five-year forward inflation expectation rate measures the expected inflation rate on average over the five-year period that begins five years from today. It has moved meaningfully higher over the past year to 2.2 percent, but is influenced by other technical factors within the TIPS and Treasuries markets, plus includes a risk premium, so it is not a pure inflation expectation.
There are many more measures of inflation expectations, but no single measure can truly forecast the future. Still, what is notable about these three indicators is that none exceed 3 percent. Although inflation may settle between 2 percent and 3 percent over the next several years rather than 2 percent or below we've seen over the past decade, consumers, economists and the markets seem to agree that we're not heading towards a sustained surge.
The writer is Global Market Strategist at J.P.Morgan Asset Management. The article was published in the report On the Minds of investors on J.P. Morgan Asset Management's website.