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What Do Financial Markets Say about Future Inflation?

The recent increase in the inflation rate, which was first noticed in 2021, has stunned financial markets and monetary officials. In only one year, the annual inflation rate as measured by the consumer price index (CPI) jumped from 1.4% in January 2021 to 7.5% in January 2022, a significant rise. The current conflict between Russia and Ukraine contributed to the May 2022 CPI inflation rate reaching 8.6%, the highest level in forty years. As a result of growing inflation, the Federal Reserve has already initiated a cycle of rate hikes to combat inflation.

The Significance of Inflation Expectation

Inflation expectations are crucial to the success of the monetary policy. If economic actors, such as individuals and businesses, anticipate that inflation will increase in the future, the sensible response is to acquire goods and services immediately to avoid higher prices. Consequently, the demand for goods and services and the price level rapidly increase, increasing inflation. To effectively battle inflation, the Federal Reserve must anchor economic actors’ long-term inflation expectations close to the inflation goal.

Inflation Expectations and Treasury Yield

The graph below depicts the cost of inflation swaps from the beginning of 2021 to the most recent accessible data for multiple periods. The blue line shows one-year inflation expectations (the one-year inflation swap), whereas the orange line reflects one-year inflation expectations beginning one year from the x-axis date (called the one-year forward, one-year inflation expectation rate). For instance, the one-year ahead, one-year inflation anticipation rate assessed in January 2021 reflects the market’s forecast of the annual inflation rate between January 2022 and January 2023.

What to Expect Amid Rising Inflation

In the first quarter of 2021, the one-year inflation outlook was mildly on the rise. In March 2021, its level exceeded the one-year ahead inflation projection, indicating that markets anticipated a higher short-term inflation rate. In May 2021, the one-year inflation expectation began to dramatically outpace the one-year ahead, one-year inflation expectation rate, indicating that the market anticipated the higher inflation rate to be temporary and to decline within a year. In contrast, the one-year ahead, one-year inflation expectation rate began to move more closely with the one-year inflation expectation rate in the second half of 2021. This suggests that market participants altered their expectations during this time period in the idea that the increased inflation may persist for a longer time.

The Federal Reserve Predicts the Possibility of Rate Hike Cycle

The second major turning point was at the end of 2021, when the Federal Reserve began to hint at a potential impending cycle of rate hikes to control inflation. The one-year nominal Treasury yield, represented by the red dotted line in the earlier figure, shows the anticipation of a rate rise policy. (See the figure’s right axis.)

Beginning this year, the one-year Treasury yield began to increase fast, indicating that market investors anticipated implementing a rate hike cycle soon. If market investors believe in the Federal Reserve’s ability to manage inflation, then longer-term inflation expectations should remain stable despite more inflation shocks. Approximately this is what has been witnessed throughout the past four months of data.

To Conclude

According to the data from inflation swaps, market participants think the Federal Reserve can and will control the high inflation rate, despite the persistence of price rises being more than anticipated. The well-anchored anticipation of longer-term inflation provides more evidence of this claim.

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