We’ve been warning about inflation for some time, at least since last fall.
At the time, an inflation prediction was counter-intuitive because prices had actually been falling during the spring. But that’s actually why inflation should have been a concern. Deflationary episodes tend to create the conditions for inflationary episodes because economists generally associate deflation with depressions, and therefore central banks are intolerant of deflation.
This desire to avoid deflation explains why the central bank created money supply aggressively during and after the deflationary episode last Spring.
There are some technical issues with M1, the definition of money as used in the chart above, and the way it was calculated was changed as of last year, so let’s look at another commonly used measure of money supply, M2:
As you can see, both traditional measures of money demonstrate that the deflationary recession caused by pandemic shutdowns was followed by a very large spike in money supply expansion. The same pattern holds during other deflationary episodes throughout history. This is why current deflation can be a risk marker for future inflation – governments try to “print” their way out of trouble.
Market indicators of inflation acted consistently with that theory. As you can see below, the inflation expectations looking forward five years rose throughout 2020. Markets shrugged off the current deflation last Spring and looked ahead to the inflation which they expected would occur later as government overreacted to a short-term drop in consumer prices by means of massive monetary stimulus.
5-Year Breakeven Inflation Rate, Annual
The data above is a high-fidelity measurement of inflation expectations in that it is the difference between two types of treasury bonds. On the one hand, you have Treasury Inflation-Protected Securities (TIPS) which compensate holders of the bonds for a loss of purchasing power by returning the original principal amount plus the change in CPI. Since they pay back investors for inflationary losses when the bond expires, they need not compensate them for inflationary losses by offering a higher yield. On the other hand, regular Treasury bonds simply return the original principal with no inflation adjustment, therefore investors who fear inflation must be compensated via higher interest yields. Since both types of bonds are Treasuries, the risk of default is the same. Since they are both 5 years in duration, their interest rates reflect the outlook over the same period of time. That means the only difference between them is based on how they deal differently with inflation. This makes the spread between the two yields a factor of inflation expectations. As an aside, another possible small difference is that TIPS are a little more complicated than regular treasuries and that diminished familiarity might affect their yield, as investors insist on a bit more of a premium to compensate themselves for the extra uncertainty of dealing with an unfamiliar type of bond.
This spread, shown above, titled 5-Year Breakeven Inflation Rate, Annual indicates that inflation risks have been rising and are now quite high compared to the historically available data (TIPS have not been around nearly as long as regular treasury bonds, so the basis of historical comparison is somewhat limited.) But even though inflation expectations are rising and are historically high, nevertheless the implied inflation rate is still not that high: As of now, inflation expectations are about 2.7%, as you can see below.
5-Year Breakeven Inflation Rate, Daily
When we look at the analytics of Google search terms, we see that searches for “deflation” peaked last spring when there was actual price deflation. At that time, money supply was spiking and market-based inflation indicators such as TIPS (which we saw above) and gold (which we will see below) were rising. In other words, the actual monetary and market data showed that the deflation was fleeting, and inflation would rise at exactly the moment the general public was focused on deflation risk. Then, as prices rose, searches on “inflation” rose with them, but did not peak until actual inflation was well underway. The pattern is that the market tends to be ahead of the general public, and the public’s attention is likely driven by media mentions and not just from price changes observed from shopping.
“Deflation” vs “Inflation” Google Search Trends
Trends in average of searches for “inflation”
Trends in average of searches for “deflation”
If the public discussion lags the economic reality, what can we learn by looking at search terms for “hyperinflation?” Hyperinflation is a very serious matter, typically 50% per month (which comes out to 600% per year), and quite rare in the developed world. Yet public attention has become focused on it, as indicated by the Google analytics data below
“Hyperinflation” Google Search Trends
If market indicators are right, or close to it, we’re nowhere near hyperinflation, which means the public discussion which was late to see the inflation danger might be focusing on an unlikely scenario.
Gold, another traditional hedge against inflation, rose during the deflationary period amidst the worst of the pandemic shut-down, but it peaked in August 2020 and has dropped in the last month:
Gold Price in U.S. Dollars
Market indicators are saying inflation risks are real, but hyperinflation is still unlikely. The basic lesson of this is: Focus on the data, not the headlines.
The opinions expressed herein are those of Vident Financial at the time of publication and are subject to change. This document does not constitute advice or a recommendation or offer to sell or a solicitation to deal in any security or financial product. It is provided for information purposes only and on the understanding that the recipient has sufficient knowledge and experience to be able to understand and make their own evaluation of the information described herein, any risks associated therewith and any related legal, tax, accounting or other material considerations. Recipients should not rely on this material in making any future investment decision.
Investors cannot invest directly in an index. Indexes are not managed and do not reflect management fees and transaction costs that are associated with some investments. Past performance does not guarantee future results.