A year ago this week, the US government told us that inflation as measured by the Consumer Price Index soared to 9.06% in June 2022 from a year earlier, the highest reading since 1981. The report sparked a crescendo of commentary around the idea that inflation was so hot, nothing less than a recession that throws millions of Americans out of a job would get it under control. Comparisons with the runaway wage-price spiral of the 1970s were ubiquitous.
It all sounded plausible if not for an inconvenient fact: one small part of the $30 trillion market for US government securities -- the daily reference of global investor preferences -- wasn't having any of it. Here, the incessant chatter that the Federal Reserve was “behind the curve” fell on deaf ears. Today, there isn't any doubt about who was ahead of the crowd. This week the government is forecast to say the inflation rate fell to 3% in June, according to data compiled by Bloomberg, something the bond market predicted a year ago.
What the bond market -- or more precisely derivatives -- showed is that the most diverse group of buyers and sellers staked their reputations and fortunes on the conviction that inflation would accelerate for two years due to the Covid-19 pandemic's worldwide lockdown before abating precipitously during the ensuing eight years. The evidence is that in the past 12 months, the market for inflation swaps succeeded in divining the path for consumer prices with an accuracy rate eluding any commentator, accurately anticipating CPI to the nearest decimal in contrast with the consensus of economists and the critics of Fed Chair Jerome Powell and President Joe Biden.
Investors hedging against rising prices traditionally turned to Treasury Inflation-Protected Securities, or TIPS, which lack the month-to-month timeliness of the inflation swaps. These derivatives enable one party to pay a fixed rate on a notional amount in return for a floating rate tied to an inflation gauge such as the CPI. For example, if one party expects consumer prices to rise at least 2.7% over the next 12 months but another thinks the most they will rise is 2.7%, they'd enter into a swaps contract with a notional amount of $1,000. The first party pays the second party $1,027 a year from now regardless of what happens to prices but gets $1,040 from the second party if CPI turns out to be, say, 4%. Inflation swap transactions are reported to the Depository Trust & Clearing Corp., a provider of clearing and settlement services to financial markets.
When so many people were fretting in 2022 that inflation was out of control, inflation swaps totaling billions of dollars 14 months ago correctly anticipated May's reading of 4% for CPI (having traded within a range of 3.1% to 4.1% for more than a year), according to data compiled by Bloomberg. Those arranging the swaps back then were convinced – correctly - the May 2023 CPI would be less than half the prevailing level of 8.6%. That was no anomaly. A month before the release of this year's April CPI data, inflation swaps were priced at 4.9% and stayed around that level until the government data was published on May 10 showing that the CPI was, indeed, officially 4.9%. Inflation swaps in March and February were similarly precise to the extent they predicted the monthly numbers, according to data compiled by Bloomberg.
Now comes the June CPI report scheduled for release on July 12, which the inflation swaps market has priced to come in between 2% and 3.3% since June 2022. If the past is prologue, the government will say consumer prices rose about 3.03% from a year earlier, or almost a percentage point lower than the previous month's report, according to data compiled by Bloomberg.
Inflation swaps totaling $82 billion last month are a shadow of the $314 billion market for TIPS. But “after tracking the data on a monthly basis, the expectations for year-over-year CPI derived from inflation swap trades have been statistically closer to the actual numbers than the economist survey consensus median,'' said Owen Minde, the Bloomberg foreign exchange and economics application specialist who manages the inflation swaps function on the Bloomberg terminal. “Equipped with the transparency of market-implied expectations for the path of year-over-year CPI, investors can compare their view versus the market's and then make their asset allocation decisions accordingly.”
That's another way of saying markets provided at least as much -- if not more -- credibility in assessing inflation as any commentator. Some economists were making this point rhetorically more than a year ago when the Fed was widely criticized for waiting until March 2022 to tighten monetary policy after inflation accelerated in 2021.
“Maybe there is an argument” that millions of people in the bond market “are weirdos who are disconnected from the inflation expectations embedded in the actors in the economy” whose “beliefs and expectations really matter because they drive decisions,” Brad DeLong, the historian and professor of economics at the University of California at Berkeley and former deputy assistant Treasury secretary under President Bill Clinton, wrote in a critique in March 2022. “Maybe there is an argument that we need to fear not bond market vigilantes, but rather other actors and agents, whose expectations of inflation have become substantially de-anchored and who are already taking steps that will produce a persistent inertial inflationary spiral.”
DeLong followed that up with a Substack posting last month, writing that “the bond market, at least, appears absolutely certain that the Federal Reserve has got this. Its implicit expectation of what inflation will be from five to ten years from now is absolutely rock-solid at a level slightly below one consistent with the Federal Reserve’s target of 2%” per year for inflation as measured by the Personal Consumption Expenditure price index.
David Wilcox, a former director of research and statistics at the Fed and currently an economist for Bloomberg Economics, asks the one question on every investor and economist’s mind. “Could earlier action by the Fed have significantly reduced the size of the pandemic-era inflation problem,” he wondered in a recent research report. “The hiking cycle began in March 2022 -- but suppose the Fed had accurately anticipated where inflation was headed and begun raising interest rates” in 2021's second quarter. “Would the inflation experience have differed greatly?” Wilcox is doubtful. “A new model developed by Bloomberg Economics suggests earlier action would have limited the inflation surge, but not eliminated it. According to this model, if the Fed had started tightening nine months earlier, CPI inflation would have peaked at 7.6% instead of 8.6%. That's not a trivial difference, but not a game changer either.”
Inflation swaps, meanwhile, are proving more effective among the tools predicting inflation than such things as the University of Michigan’s monthly inflation survey of 600 randomly selected households, the about 60 economist forecasts regularly compiled by Bloomberg, and breakeven rates in the Treasury market that suggest the average rate of inflation over the following one, five, 10 and 30 years.
So, what are they predicting now? A further gradual slowing in inflation to well below 3% over the next 12 months. And all those economists who said only a deep recession would cut inflation? Many of them are now saying the economy may avoid a downturn. You can’t make this stuff up.
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