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Everybody loves buying things on sale. Lower prices feel good. But when you apply lower prices across the entire economy, it spells trouble. This is especially true for borrowers of capital. If you owe money, inflation can be helpful as you pay the debt back in the future with inflated dollars. The opposite is true for lenders.
If you follow the news about central banks, either domestic or foreign, you have probably noticed an increased effort by central banks to achieve core inflation targets. The Fed has not always had a numerical inflation target. It was not until 2012 that they explicitly adopted 2% as the target, though it was an implied target for decades before that. So why do inflation targets matter? In the end, it really comes down to how people and businesses make decisions about expenditures that drive economic growth.
Lower inflation levels, especially when persistent, can lead to lower inflation expectations and erode confidence in the Fed’s ability to meet its symmetric 2% inflation objective. You can see the impact of this domestically through two measures, one driven by the market and one survey based.
Thanks to the U.S. Treasury Department’s introduction of Treasury Inflation-Protected Securities (commonly referred to as TIPS) in 1997, there is a publically traded instrument that measures the market’s expectations for future inflation. After reaching nearly 2% in late April, the 10-year breakeven inflation expectation according to the TIPS market has fallen by almost 40 basis points, and the real yield on 10-year TIPS is now 0%. This is exactly the kind of dis-inflationary pressure the Fed would like to see go away.
In addition, the University of Michigan conducts a monthly consumer survey, which inquires what level of price inflation participants expect over the next five to 10 years. While the median survey data has ticked up in the last month, it has been bouncing around a historical low of 2.3% over the course of 2019.
When consumers and businesses expect lower inflation, they may be less concerned about paying more for the same goods in the future. As a result, they may delay consumption or investment behavior. The extreme example of this occurs when an economy drifts into deflation. In deflationary environments, people can get more for their money in the future than they can today, which actively encourages delaying purchases. Since consumer and business expenditures make up approximately 80% of the economy, it is easy to see the potential impact on GDP growth rates.
Not everyone agrees that achieving inflation targets matter. Some critics point to the weightings of certain goods and services in inflation calculations and infer that several large components of expenditures are under-represented. A few of the typical examples that are cited are health insurance (just over 1% of the Consumer Price Index (CPI)), tuition and childcare (roughly 3% of the CPI), and even housing costs (about 33% of CPI). Anyone who has to pay for these expenses on a regular basis can tell you that they can amount to far more of a household’s total expenditures than the way they are represented in the CPI.
Our response to those folks would be that economic growth occurs based on marginal increases in activity. The amount of consumables, either purchased or not, really matters in terms of marginal consumption behavior that has an outsized impact on actual economic growth.
Note: TIPS adjust the principal balance payable to investors over time for the rate of inflation measured by the Consumer Price Index (CPI). Because of this inflation adjustment, the yield on TIPS is referred to as the “real yield” since it is an after inflation return. The spread between the yield on a nominal Treasury note and the TIPS with a corresponding maturity date is referred to as the “breakeven” inflation rate, which indicates the average rate of CPI inflation the economy would have to experience over the life of the securities in order for the real return of each to be equal. The “breakeven” inflation rate can also be interpreted as the market’s overall expectation of what CPI inflation will average over the life of the security.
Past performance is no guarantee of future results. Opinions are as of the publication date, subject to change and may not come to pass. Information is for informational purposes only and should not be considered investment advice.
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