How does the Market price in future Inflation?
These days the headlines of any financial paper highlight the extremely low inflation (<2%) and its expectation to stay at these levels for a long time ahead (5-10 years). This number is both surprising and difficult to comprehend as not too long ago in the late 80s/early 90s, inflation would frequently hit double-digits, and even as recently as mid-2000s inflation was materially higher than it is today.
So, what is the news actually referring to, when it talks about future inflation? How is it possible to predict the future?
The short answer is that the pundits don’t really know. The information is based on a Break-Even-Inflation Rate 5 years or 10 years forward, commonly known as BEI.
So what is BEI?
In formal terms, BEI is defined as the Interest Rate that compensates bond investors for inflation risk. In layman terms, this means that if an investor purchases a government bond and holds it to maturity, he certainly doesn’t want to lose his purchasing power to inflation. Therefore, he has to be compensated for future Inflation and thus at the time of purchase the bond will be offered a yield (interest rate) that will include expected inflation for the life of the bond. This rate is BEI.
Most of us will be asking ourselves, how can the market really know what inflation will be in the future? It has to be that way otherwise buyers wouldn’t really be compensated for it. The truth of the matter is that the market doesn’t know, it is just the best guess of the market. It is similar in concept to the value of a stock – which is simply the future expected cash-flows that are once again a best guess of the market.
So, how good has the market historically been in determining future inflation? Let’s find out. To do so we take the historical 5-year BEI rate, which in theory should give us what the market is expecting inflation to average over the next 5 years, month by month.
We then take a rough measure of realized inflation, i.e. the Consumer Price Index and we derive from it the average inflation realized over 5 years, month by month. This allows us to compare realized inflation from Dec 2007 to Aug 2008 vs what the market was expecting 5 years before that.
If we remove the drop of 2013, we can see that for the most part, historically BEI has overestimated realized inflation, and that is what we would expect. Because in the long run for an investor to truly be compensated for inflation risk, the rate of inflation priced in (BEI) should be superior to realized inflation.
However, that story does not resonate with the 2013 drop.
Why did BEI materially underestimate realized inflation?
The truth of the matter is that we always need to remember that BEI is a “market estimate” of inflation and not an economic leading indicator. In other words, we are using market prices to determine a future economic statistic. And as you can imagine markets can be irrational for short (sometimes not so short) fragments of time.
In the specific case of 2013, the sudden drop in BEI was due to a massive sell-off of inflation-linked bonds in the financial crisis of 2008. Market players were more interested in making sure their funds would move to safer and more liquid asset classes, such as US short-term government t-bills (also known as Cash), as opposed to acting rationally and holding on to inflation-linked-bonds.
This fear led to a unique case in which the market was pricing in negative inflation over the subsequent five years – which in hindsight seems absurd. However, what is important to note is that special situations like this do come around from time to time and usually are very short-lived.
In essence – as with every other statistic or fundamental value that is inferred by market prices, be careful when using it to predict future expectations.
Nevertheless, BEI is an important component to help you understand the mechanics of inflation expectations in the markets.