Sep 27, 2021
Have consumers' long-run inflation expectations become un-anchored?
By Larry Berman
Larry Berman: Inflation pressing cyclical high
Liberty Street Economics is the research arm of the New York Federal Reserve Bank. In August, they conducted their monthly survey of consumer expectations (since June 2013). They ask about many aspects of consumer behaviour, but here they focused on short and intermediate inflation expectations. As you can see by the graphic, while not unhinged, are clearly pressing cyclical highs.
The Federal Reserve defines when:
“inflation expectations are considered un-anchored when long-run inflation expectations change significantly in response to developments in inflation or other economic variables, and begin to move away from levels consistent with the central bank’s (implicit or explicit) inflation objective.”
In July 2019, April 2021 and August 2021, the researchers asked special questions about forward expectations. To measure long-run inflation expectations, they asked respondents the same question, but replaced “Over the next 12 months” with “Over the 12-month period between M+48 and M+60,” where M is the month in which the respondent takes the survey. So, for instance, a respondent taking the survey in August 2021 was asked about inflation “Over the 12-month period between August 2025 and August 2026.”
You can read the full summary here.
The conclusion of the research suggests that “transitory” is the most likely outcome and this is what the markets are priced for. Liberty says that “long-run inflation expectations are as well anchored in 2021 as they were in 2019.” They reference a series of experiments in which we measured the sensitivity of five-year ahead inflation expectations to persistent hypothetical shocks to past inflation and to hypothetical surprises in future near-term inflation. For instance, respondents were asked to report how their five-year ahead inflation expectations would change if “in each of the past three years inflation had been lower than it actually was by 1 percent each year” or if “the rate of inflation over the next 12 months turns out to be one per cent higher than you [currently expect]?” The results of these experiments indicate modest revisions in long-run inflation expectations in all treatments, and revisions of similar magnitude in the surveys conducted in 2019 and in 2021. Further, the proportion of respondents who appear to have perfectly anchored inflation expectations (in the sense that their long-term inflation beliefs were completely unresponsive to inflation shocks) remained remarkably stable around 40 per cent over the past two years.
The Federal Reserve Bank of St. Louis hosts a robust economics database. The Fed’s favourite measure of inflations expectations is the market based (meaning not using sentiment like above, but financial instruments) measure of forward based inflation expectations. What will the five-year inflation rate be five-years from today? You can follow the number here. This may be the most important chart in the coming years as it will likely define the “path” of Fed pulling back on their easy money policies.
But if you do not believe that this is the likely outcome, there are a few new ETFs designed to help with the bond market becoming unanchored. So how does one protect the fixed income part of their portfolios that for many represent 30 per cent or more? Here are two relatively new ETFs designed to hedge inflation risks in fixed income markets with sophisticated derivatives. To be sure, these are not “buy and hold” ideas for all investors and we highly recommend you understand them before incorporating them into your portfolios.
PFIX: The Simplify Interest Rate Hedge ETF seeks to provide a hedge against a sharp increase in long-term interest rates. The fund holds a large position in over-the-counter (OTC) interest rate options intended to provide a direct and transparent convex exposure to large upward moves in interest rates and interest rate volatility. Using OTC derivatives usually only available to institutional investors, PFIX is designed to be functionally similar to owning a position in long-dated put options on 20-year US Treasury bonds. Since the option position is held for extended periods the ETF provides a simple and transparent interest rate hedge.
IVOL: is a first-of-its-kind fixed income ETF that seeks to hedge relative interest rate movements, whether these movements arise from falling short-term interest rates or rising long-term interest rates, and to benefit from market stress when fixed income volatility increases, while providing the potential for enhanced, inflation-protected income.
And stay tuned for the announcement of our fall virtual roadshow later this week. It will begin Oct. 7 and run every week until early December. Each week we will cover a key part of your portfolio from how to protect against inflation risks to generating yield and income.
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