How Long Will High Inflation Last?
This is the third article I’ve written on this topic since inflation started spiking late last year. Currently we’re experiencing significant increases in the cost of gasoline, food, and other staples. And this is a world-wide phenomenon, not just in the U.S. With the media hyping the current level of inflation as the worst in decades, it’s easy to get wrapped up in the drama and emotion of the situation. I’ve already covered the various sources that are driving inflation right now. But I’m sure the most important question on everybody’s mind continues to be “will we ever see inflation return to the levels we’ve become accustomed to over the last decade?”
The answer, as always, is nobody can predict the future. However, we can look to the capital markets to at least get the perspective of millions of investors who vote with their dollars. After all, the prices of securities collectively reflect the market’s expectations of future economic growth. In particular, there’s a measure called break-even inflation (BEI) that provides a window into the market’s expectations about inflation.
BEI is the difference between the current yield on treasury bonds (“treasuries”) and inflation protected treasury bonds (TIPS) having the same maturity. As of this writing the 5-year BEI was 2.9%. That means if actual inflation over the next five years were to exceed that amount, TIPS will have provided a better return than treasuries. If not, then treasuries will have been the better investment. While many investors use this data to make investment decisions, you can also use it as a reflection of the overall market’s expectation of the average annual inflation rate over the next five years. A 2.9% average inflation rate is not significantly higher than the historical inflation rate over the last century, which suggests that the market expects inflation to decline significantly over the next five years.
Although the government also issues one and two year treasuries, there are no TIPS equivalents. But a shorter-term BEI can be calculated using 5-year TIPS issued four years ago that have approximately one year remaining before maturity. The 1-year equivalent BEI right now is under 5%.That’s the market’s view of the average level of inflation over the next year, quite a bit less than the current actual inflation rate of 8.6% reported in May.
BEI fluctuates regularly since market expectations and interest rates can change on a daily basis. And while group think is generally much better at guessing the future than individuals are, it’s not infallible. On May 3, 2021 the 1-year BEI was only 2.7%. The actual one-year inflation rate as measured by the change in the CPI from May 2021 through April 2022 turned out to be 8.3%. In other words, a significant portion of that period’s inflation was completely unexpected.
In short, while it feels as if we will be living with severe inflation for a long time, the market doesn’t think so. Investors are betting on a much more benign environment starting later this year and into the foreseeable future. Of course, they could be wrong. But they could also be right. That’s encouraging enough for me.
Nice! I’d never heard of BEI. Cool concept.