The Bureau of Labor Statistics reports the CPI-U index. The reported end December number of 1.7% tells us that the price of goods and services has increased by that much over the past year.
Interesting, but it doesn’t tell us much about the future rate of inflation and therefore how it will affect our future purchasing power.
A better indicator of future inflation, one that the Federal Reserve keeps a close eye on, is the 10 year breakeven rate. The breakeven rate is a measure of the expected rate of inflation over a certain period of time. It is calculated by measuring the difference between the nominal yield of government bonds and the real yield of inflation linked government bonds. In this case, the 10 year bonds.
The expected rate of inflation for the next 10 years shows that investors expect inflation rates to rise from 1.7% to 2.6%.
This doesn’t appear at first to be a big change, but as the chart below shows, 2.6% is as high as inflationary expectations were before the crisis, when the economy was growing at a speedy rate and unemployment levels were low.
Given that the economy is stalling and the unemployment rate is at 7.9% what other factors could explain this rise in inflationary expectations?
One likely cause is the FED’s QE program, which has expanded its balance sheet by US$2.5 trillion since 2007. To put this in context, it took almost 100 years for the Fed to build its balance sheet to US$0.9 trillion and it then almost tripled this in the last four years! This new money has essentially been created out of thin air and, as it continues to find its way into the real economy, its effects will increasingly be felt by consumers. The simple economic principle of prices being determined by supply and demand tell us, very simply and elegantly, that once the supply of dollars increases so substantially, surely its price must fall. Or in other words, the price of good relative to the dollar must rise considerably to balance the oversupply of dollars.
Inflationary expectations could rise considerably from here. Watch this space!
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