One of the topics we like to revisit time and time again is our calculation of the inflation, measured in CPI, that the market is expecting over various timeframes. We most recently looked at inflation expectations at the end of August, and noted a recent uptick. In fact, you don’t even have to wait for our updates to get a quick gauge of the readings – we built an inflation breakeven calculator some time back which does the math for you.
But What If The Market Doesn’t Know?
Well, conceptually, the point of the breakevens isn’t so much to say that “this is definitively going to be the path forward for inflation” so much as “this is the inflation reading which means neither non-inflation nor inflation protected securities had the advantage in return”.
There are many reasons you might pick Treasury Notes over, say, TIPS – and many of them have nothing to do with inflation. Ease of use, understanding, liquidity preferences, holding requirements, even tax treatment and type of account you hold securities in is going to make a difference in what you pick.
Think of inflation expectations with all those little inaccuracies like those “electrical body fat percentage” scales, which are notoriously inaccurate.
Sure, they’re inaccurate – but directionally, if you measure around the same time of day in similar conditions… you’ll see a trend. Likewise, if the market is pricing in 3% inflation over the next five years when yesterday it was pricing in 2% inflation? Yeah, something significant happened.
Enter the San Francisco Fed
The San Francisco Federal Reserve recently released a report on the accuracy of inflation forecasts – finding, perhaps hilariously, that just projecting a flat constant inflation rate out into the future was the best method of predicting inflation in a year or two. And, yes, market forecasters were more accurate than the ‘market’ at large – at least judging by inflation swaps (there wasn’t really enough data using the TIPs method we use – maybe DQYDJ can pick up the cause?). Even just projecting the current inflation out a year was better… but see for yourself.
Here’s the accuracy of the various methods over the timesframes tested:
Does it Matter?
Okay, so there isn’t a ton of history to compare inflation expectations with… but already, expectations don’t seem to line up too perfectly with reality, especially when there are other methods of forecasting inflation.
But here’s the important thing – yes, the majority of you should still be passively investing in an age-appropriate fashion. However, if you do choose to go the individual investment route, you better have an eye on inflation. Hopefully this article helps you decide what, exactly, you’ll be looking at!