What is the way out?
Many investors are wondering how it is possible that inflation is running close to 8%, but the 5 year forward breakeven rate implied by the TIPS markets suggests that inflation will be approximately 2%? The Fed too, has talked about how future inflation will approach 2%. That seems like a long shot right now. But is it?
The below chart of inflation through the 1970s shows how this is possible. Inflation typically causes the Fed to raise interest rates, which can slow the economy or even induce a recession, and temper demand. On the other side of the inflation equation, supply shocks tend to get worked out in time. Both factors can result in inflation declining, and sometimes rapidly.
Inflation through the 1970s
Nuances to consider
- During the 1970s, inflation increased close to 10% from low to high. Today, inflation has risen almost 8% from low to high.
- Inflations regimes historically haven’t lasted much longer than 3 years. Today, we are currently 2 years and 5 months into this inflation regime.
- After some sputtering, the Fed has been highly reactionary to this inflation regime, raising the Fed Funds rate at a near record pace.
- Just like in the 1970s, a major component of this inflation regime is supply shock. Is the war in Ukraine or are supply chain issues permanent factors now?
- Every general not only fights the last war, but they also expect the worst war. In capital markets, the worst case rarely materializes.
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Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in the general level of prices, often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods.
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