Expectations for inflation are critical to how fast the Fed raises interest rates.
Frederic J. Brown/AFP via Getty Images
Good news about inflation is bubbling up even as the Federal Reserve raises interest rates and stocks plunge.
Right now, the market is indicating that inflation is expected to average 2.86% a year for the next 10 years, according to data from the St. Louis Fed on the so-called 10-year Treasury note break-even rate. That might sound low, given that the consumer price index rose at an annual rate of 8.5% in March.
But inflation has long been expected to slow down. The logic is that demand will decline as consumers spend the excess cash they built up during the pandemic crisis, while supply-chain constraints gradually moderate. The question is how rapidly annual inflation will decline.
The latest data seems favorable. In the first place, inflation expectations as measured by the 10-year break-even rate appear to have hit a peak of 2.98% in late April. That was a 19-year high and marked the third time during the pandemic that the rate went into the mid two-nineties before promptly declining.
That reflects that there wasn’t much in the recent economic data to create expectations that annual inflation would average more than 2.98% over the next 10 years. That, too, makes sense. After all, the Federal Reserve is adamant about reducing inflation and has made it clear it will lift short-term interest rates many more times from here in order to curb economic demand.
Expectations for inflation are important because if the public expects rapid increases in prices, employees will demand higher wages, and companies will charge more, forcing workers to ask for more money. Lower expectations make the Fed’s job easier.
They also matter because they influence how quickly—or slowly—the Fed raises rates. Slower rate increases are better for economic growth, the S&P 500, and the stock market in general.
The second signal is that actual inflation, rather than expected inflation, has probably peaked too. Prices across the economy increased rapidly in 2021 versus 2020 levels, with CPI gains of more than 5% in the middle of the year. Because prices were high a year ago, the year-over-year increases are likely to moderate.
Historically, when gains in the CPI hit their high for a given economic cycle, it often means 10-year inflation expectations peak, too. In 2000, 2005, 2008, 2011, and 2018, the CPI hit peaks. Ten-year inflation expectations declined in the following 12 months four out of those five times, according to Citigroup data.
Peaks in oil prices tell the same story. This year, the price of West Texas Intermediate crude oil has fallen to $110 a barrel from a multiyear high of $130, hit in early March. In 2008, 2011, 2013, and 2018, the price of oil hit multiyear peaks, and 10-year inflation expectations fell for the following 12 months in three of those four instances.
If expectatlons for inflation have truly topped out, that should boost the stock market. It means the Fed will be less aggressive in lifting interest rates than currently expected. Already, the Fed said this week that it is unlikely to lift interest rates by increments of 75 basis points, or hundredths of a percentage point, leaving 25 to 50 basis- point increases as the likely move.
Stocks are still under pressure because the market is still trying to gage the full extent of the economic and earnings impact from higher rates to come. But the S&P 500 is finding a floor where buyers step in. The index has repeatedly stabilized at around 4,070 this week. It ended Friday at 4123.34.
Write to Jacob Sonenshine at [email protected]
