When someone asks me if I still think the recent inflation is temporary, I say temporary means as long as the pandemic disrupts the balance between supply and demand. Note: demand. I get a lot of emails telling me that Modern Monetary Theory (MMT) is a fraud because of soaring inflation and our denial of demand (spending) participation. Clearly, the data shows that large fiscal deficits and central bank bond-buying programs always lead to inflation. Nice try. I last provided data and analysis on this issue in this blog post – Central banks are fending off inflation scare hype from financial markets – so we’re better off (December 13, 2021) – I am here to make it clear that the spike is a unique coincidence between an unusual, pandemic-related demand and supply pattern. It couldn’t be clearer. When this imbalance occurs, coupled with cartel-style price gouging (unrelated to fiscal or monetary policy settings), the MMT predicts that a country will face inflationary pressures. The idea of defining an economy as periods below full capacity in the absence of inflation and periods above full capacity in the presence of inflation is not part of the MMT body of knowledge. It’s more complicated than the dichotomy we’ve covered in textbooks — macroeconomics. Supporting this view is a recent ECB research paper that uses fairly advanced econometric techniques to decompose a measure of inflation expectations into a component that reflects short-term risks and another that reflects long-term inflation expectations. part. They found that the former is driving the current inflation trajectory, while the latter is largely stable. This means that, in English, current inflation is likely to be short-lived, driven by how long the pandemic has disrupted supply chains.
In the August 2021 edition — ECB Economic Bulletin, No. 8/2021 – The ECB publishes several special information boxes highlighting statistical work in relevant and areas of interest.
Box 4 – Decomposing market-based inflation compensation measures into inflation expectations and risk premiums – Has a complicated-sounding title and uses sophisticated econometric analysis to produce results, however, the message is simple.
The “market” does not expect inflation to accelerate in the medium to long term, and the factors driving inflationary pressures in the near term are considered temporary, related to the massive disruption caused by the pandemic.
Trying to build a narrative that these factors are directly related to irresponsible fiscal and monetary policy settings designed to protect jobs and incomes in the short term during the raging pandemic is an impossible task.
The overarching theme of Issue 8 is to align the current ECB policy settings (stable and low interest rates and massive bond-buying programs) with the evolving economic conditions as we navigate the pandemic, especially since the Omicron variant. Economic conditions side by side.
… economic activity suggests that growth momentum at the start of the fourth quarter remained weak, particularly in manufacturing, due to the aforementioned supply bottlenecks, while the services sector benefited from the reopening of large economies.
In its December 2021 Eurosystem staff macroeconomic forecast for 2021, the ECB downgraded its future growth forecasts, partly due to the “adverse impact of persistent supply easing in the second quarter of 2019 “and fully eased by 2023”.
The combination of persistent supply constraints and recovering demand means prices will rise as long as the imbalance persists.
Like they say:
The future course of the pandemic remains a major risk to the global economic baseline forecast.
This is the basis for viewing trends as transitory, as there does not appear to be an institutional structure in place that could act as a sustained transmission mechanism to drive structural inflationary biases, as was the case with the wage price wars of the 1970s after oil prices rose.
More specifically, the ECB agreed:
Inflation is expected to remain high in the short term, but to decline over the course of the year. The rise in inflation largely reflects sharp increases in fuel, natural gas and electricity prices. Energy inflation accounted for more than half of headline inflation in November. Demand in certain industries also continued to outpace constrained supply. The consequences are particularly evident in the prices of durable goods and recently reopened consumer services.
Importantly, they show that “market- and survey-based measures of longer-term inflation expectations have remained broadly stable”
How the financial markets tell us anything about the likelihood of inflationary pressures.
A common measure is Inflation Linked Swap (ILS) Interest rates, considered a proxy for inflation expectations.
The 5-year and 5-year ILS are widely used as indicators of short- and medium-term price change expectations, while the 10-year and 10-year ILS are long-term inflation expectations.
When two parties enter into an ILS contract, one party agrees to pay a fixed cash flow on a nominal basis, while the other party agrees to pay a floating rate that is directly related to an inflation index such as CPI.
Its purpose is to transfer inflation risk from one party to another through fixed cash flows. Hedgers are willing to pay for reduced uncertainty, while the other side speculates on the trajectory of inflation.
If the inflation rate during the contract period is higher than the swap rate, the person paying the fixed rate will profit, and vice versa.
The ECB noted that 5-year and 5-year interest rates have risen in 2021 due to factors such as “continued supply chain tensions and rising energy prices,” although evidence from other indicators was mixed.
They assessed that “the market is pricing in higher inflation in the euro area in the short term”.
But how persistent is this “pricing” sentiment?
Not quite based on the same data.
The ECB stated:
At the same time, they are still pricing the rise in inflation as temporary, with ILS forward rates at around 1.7% a year later and five-year ILS rates a little higher at 1.8% after five years.
This brings me to the research box provided by the ECB to further clarify this point.
In box 4 – Decomposing market-based inflation compensation measures into inflation expectations and risk premiums – A static decomposition of the inflation-linked swap rate (ILS) executed, separating factors related to risk premiums from those related to changes in expectations.
The verdict is clear – ILS rates go up:
…mainly related to a shift in priced inflation risk from below-expected to above-expected.
what does this mean?
This means that players trying to make money using these financial instruments do not expect inflation to accelerate in the long run.
The ECB provides this graph (first panel of Exhibit A) showing the evolution of different ILS rates (1, 5 and 10 years) in the euro area.
It shows that while ILS rates were “relatively stable from 2005-07”, they plummeted during the GFC (inflation fell sharply) and then plummeted again early in the pandemic (March 2020).
As supply constraints tightened, ILS rates began to rise, with short-term rates rising faster and higher than medium- and long-term rates.
Note that the longer rate is only around 2%, which most central banks see as a sign of price stability.
Although the ECB notes that the ILS rate “reflects not only the actual inflation expectations of financial market participants, but also an inflation risk premium”.
We know that when there is a major supply disruption, the inflation risk premium for risk-averse financial market participants rises sharply.
For demand shocks, the opposite is usually observed.
In the case of supply bottlenecks, traders looking for real gains are demanding a higher risk premium in these swaps.
I will not detail the econometric techniques used by ECB researchers to differentiate these two drivers of ILS swap rates.
I just want to say they are standard, I have no problem with them.
The modeling found that “short-term ILS rates converge to a fixed number in the long run” (a statistical property of this type of fixed term structure model).
They calibrated that ratio to 1.9%.
The overall conclusion is:
… Inflation expectations are generally more stable than the ILS rate, and there have been signs that the inflation risk premium has changed over past periods, including recently.
This means that financial markets have been adjusting their inflation risk premiums.
The premium was negative in 2013-14 as “the risk of a lower-than-expected inflation outcome is increasingly taken into account by the market”.
Risk premium estimates have risen during the recent pandemic as the economy resumed higher levels of activity amid tight supply constraints and risk premiums are now positive.
The ECB concluded that the financial market participants are:
… With persistent supply bottlenecks, it is more likely, or at least a risk, that the economy will be dominated by supply shocks for the foreseeable future.
We know that these bottlenecks will ease once the pandemic eases.
Then the risk premium will switch signs again and the ILS rate will drop sharply again.
While some may struggle to understand this material, the results are fairly straightforward.
There is no solid evidence that financial market participants who bet based on a desire for real profits (i.e. not being affected by inflation on the value of a currency) believe that inflation will accelerate and be higher than in the long run.
They are assessing that increased spending is making the deal riskier as the economy reopens to deal with persistent supply constraints, but that risk is largely short-term.
Evidence suggests that these risks will decrease once the supply side eases and different industries (such as goods production and services) return to some normalcy, and shipping and air freight adjust.
That said, further evidence that my assessment of the current inflation surge is short-lived.
But short-lived may not mean lasting days or months.
It all depends on how long the pandemic proves to be.
Enough for today!
(c) Copyright 2022 William Mitchell. all rights reserved.