Doubt it, inflation has peaked!

As we all know, June CPI data was just released in the US last Wednesday:

It rose to 9.1 percent from 8.6 percent the previous month, another 40-year high.

Unbeknownst to everyone, on Friday night, the University of Michigan released the most important number in its survey of market sentiment, consumers’ five-year inflation expectations:

It plunged to 2.8% from 3.1% the previous month, the lowest level in the past 12 months.

Note: After 2015, the University of Michigan survey inflation expectation data for more than 5 years were released at the middle of the month and at the end of the month respectively. The data of the middle of the month is used in this chart. The data of inflation rate and survey inflation expectation data are from the Eastern Wealth Choice and the University Michigan Consumer Survey Center respectively.

It is strange why inflation figures have soared while market surveys of inflation expectations have plunged

Is Mr. Market schizophrenic?

In “Has Inflation Peaked? In this article, I have mentioned that the official inflation rate indicators of the United States are a bit complicated. The most basic indicators are CPI, PPI, ECI, PCE and GDP Deflator. On the basis of these five basic indicators, the U.S. government and the Federal Reserve will also release core CPI, core PCE, and core CPI. Median CPI, median PCE, truncated mean CPI, truncated mean PCE and other inflation correction measures.

The data, best known as the University of Michigan’s Inflation Expectations Survey, includes inflation expectations over a 12-month period as well as the above mentioned medium – and long-term inflation expectations over a five-year period.

The 12-month inflation expectations data, published since 1978, closely tracks America’s official inflation rate and basically represents market expectations for inflation over the next 12 months (see chart).

Although America’s official inflation figures have hit 40-year highs since March 2022, 12-month inflation expectations in the University of Michigan survey have been flat and have recently fallen (see chart).

The most widely used statistical inflation expectation, commonly referred to in markets as the “breakeven inflation rate”, and is calculated by taking the yield on Treasury bonds of the same maturity, minus the yield on TIPS issued by the US Treasury.

Because the yield on TIPS is generally viewed as the market’s real dollar yield, and the yield on Treasury bonds represents the nominal dollar yield, the subtracted from the yield is naturally the market’s expected rate of inflation — the market’s expected break-even rate of inflation, divided into five -, 10 -, 20 – and 30-year maturities, depending on the maturity of the bonds.

Because this inflation forecast is calculated daily from bond prices, it is the most sensitive of all inflation expectations – excluding the manipulation of bond prices by the Treasury and the Federal Reserve, it reflects the market’s trading of inflation rates in five years, 10 years, 20 years and 30 years, respectively.

In addition to this high frequency of inflation expectations, in 2019 the Federal Reserve’s Cleveland branch got the trick of directly using market data on nominal yields on five – and 10-year Treasury bonds, subtracting the Treasury Department’s adjustment of recent inflation data, to come up with an expected inflation rate five years from today.

That number is called the Forward Inflation Expectation Rate. This data is also available daily, going back to 2003, and the chart below is the Cleveland Fed’s calculation of five-year forward inflation expectations versus five-year breakeven inflation.


In addition to forward inflation expectations, the Cleveland Fed, which is very “expert” in inflation research, has devised a monthly calculation model using Treasury yields of different maturities, CPI inflation and then combined with market inflation Swaps and Michigan survey inflation expectations. Can estimate Expected Inflation, real interest rates and risk premiums for each of the next 30 years,

Note that my chart above only lists inflation expectations for 1-5, 7, 10, 15, 20, 25, 30 years. In fact, the Cleveland Fed estimates and publishes inflation expectations and real interest rates for any year from 1-30 years, such as 6, 8, 9, 11, 12… 28 years, 29 years, 30 years

That is an overview of official and market inflation expectations.

Of the many inflation expectations figures above, there are only four that I personally focus on:

1) Expected inflation as indicated by 5-year TIPS and Treasury yields;

2) Expected inflation as indicated by 10-year TIPS and Treasury yields;

3) The University of Michigan surveys 12-month inflation expectations;

4) The University of Michigan surveys inflation expectations over five years.

According to my personal understanding, “inflation expectation” itself is a psychological expectation and estimation of the future. It is sufficient to have short-term (12 months) and medium – and long-term (more than 5 years) survey data, as well as medium – and long-term data from market trading games.

The bunch of inflation expectations the Cleveland Fed variously estimates is just air to air, not much.

A few more words here

In countless marketing campaigns, many people have a special admiration for the Federal Reserve, the US government or some government policy makers, saying that they seem to know everything and know everything, and that they are concerned with the life of the world and the future of a thousand years. Any decision they make is a big pattern, a big strategy, a big thinking, and a far-ranging, forward-looking thinking. Or have particularly ambitious or long-term goals and plans…

Unfortunately, I scoff at any of these ideas. I always believe that they are ordinary people, they may have more data and information than ordinary people, more in-depth, so when making decisions, there are more bases, but it is not to say that they are gods, do everything wise.

No matter what position I sit in or what I do, I still have to build it step by step on the basis of reality. I think it is delusional to want to design any grand framework and goals that are divorced from reality.

In the case of inflation in the United States, the Fed must also consider what to do on a realistic basis, step by step, and then, depending on the feedback, make further moves.

1) When the global coronavirus pandemic hit in February 2020, both the real inflation rate in the United States, the break-even rate expected by the market, and the University of Michigan survey inflation expectations plummeted;

2) Seeing the danger of a complete shutdown of the US economy, the Federal Reserve began to print money frantically to save the market. Although the real inflation rate in the US remained low, the inflation expectations traded in the bond market began to rebound rapidly. But the smartest was the University of Michigan’s survey of inflation expectations, which quickly reversed to more than 3%.

3) Official inflation remained low until March 2021, so the Fed printed money recklessly, but the University of Michigan survey of inflation expectations began to rise rapidly and well above 2019 levels, especially the 12-month survey of inflation expectations, which is almost always a leading indicator of official inflation in the United States;

4) As the inflation rate continued to “far exceed expectations”, the Federal Reserve realized its “overshoot” of printing money and began to consciously control the speed and scale of printing money, hoping that inflation would “subside naturally”. However, the supply chain tension caused by the epidemic and the outbreak of the Russia-Ukraine war continued to push up the inflation rate in the United States, and the Federal Reserve was forced to significantly raise interest rates and shrink its balance sheet. But inflation remains high…

Compared with the University of Michigan survey data, the inflation expectations shown by the Cleveland Fed model are a joke.

By March 2022, even after the actual inflation rate has reached more than 8%, the Cleveland Fed’s model still suggests that the inflation rate will be below 2% in the medium to long term. This may be precisely the confidence that Powell has been insisting that “inflation is transitory”.

Further, it is necessary to ask:

Why did the University of Michigan’s survey of inflation expectations, particularly over the medium to long term, plunge from 3.3 per cent to 2.8 per cent, a one-year low?

And the answer is —

Gas prices and rents, on top of recession expectations

The research department of China International Capital Corporation disaggregated the CPI in the United States in the last three months and found that, from the analysis of year-on-year factors, basically fuel, gas, rent and air tickets pushed up the CPI inflation rate in the United States, while other indicators did not change much.

Many people may not understand, in late June, the market price of crude oil has fallen sharply, why the US CPI component, fuel data did not ease at all?

The reason is that the transmission from crude oil prices to fuel prices takes about half a month to a month. If crude oil prices do not rise again, the fuel component of the CPI in the next month should be significantly lower than it was in May and June.

If a recession approaches or comes, demand in the US economy will fall sharply, which will bring about a sharp drop in market inflation.

In the face of a string of 40-year highs in U.S. CPI inflation, 12-month inflation expectations in the University of Michigan survey have fallen for three straight months, as markets have started to price in a slowdown in energy and rent growth.

As for medium – and long-term inflation expectations over five years as measured by the University of Michigan survey, they fell sharply this month, suggesting that market participants have started to price in a recession.

Given all this, it is doubtful that the probability of inflation in America has peaked.


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