Quantitative strategy
07 February 2022
By Lukas Gehrig, Zurich Switzerland, Quantitative Strategist; Nikola Vasiljevic, Zurich, Switzerland, Head of Quantitative Strategy
Steering and anchoring inflation expectations through forward guidance has been the name of the game for central banks since the 1990s. Recent surveys for US inflation expectations suggest that anchors that have held for 20 years may be nudging up. However, quantitative analysis suggests that this shift is too small, so far, to be worrisome for financial markets.
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Inflation expectations in financial markets rely heavily on central bank statements. In the US, this success-story for policymakers started in 1994, when the Federal Open Market Committee first issued statements on monetary policy decisions. From 2000, it also provided a risk assessment for the economy, indirectly guiding markets expectations for the likely path of rate moves. Around that time, long-term consumer price index expectations became firmly anchored (see chart).
Recent surges in anticipated five-year inflation from professional forecasters give rise to questions regarding the strength of inflation anchoring of late, and possible consequences of a weaker anchor.
There is no one measure for anticipated inflation. Depending on whom you survey (or measure), the answer differs. Survey responses from consumers have historically been up to one percentage point above those of professionals, which makes the recent surge in expectations look even more dramatic. Market-implied data reflect not only “pure” inflation expectations, but also demand for external factors, such as hedging for pension fund portfolios.
All these measures have experienced a recent surge and in the case of the five-year measure, this surge reached highs unseen since the turn of the millennium. The dispersion of forecasts by professionals – measured by the distance between the 25th and 75th percentile – is as high as it was during the global financial crisis. Meanwhile, 10-year expectations have merely been brought back to their pre-global financial crisis measures (see chart).
Surveys of inflation expectations suggest that long-term anchors have nudged a little, but not left the ground. Meanwhile, uncertainty around the US inflation rate in five years’ time has grown considerably.
To test the strength of the anchoring, our regression model seeks to explain the quarterly change in professional survey expectations, by surprises against past expectations, while controlling for the economic cycle.
The chart shows estimates of anchoring coefficients from three-year rolling regressions. A high and statistically significant estimate for the anchoring coefficient indicates that forecasters are revising their long-term inflation expectations based on the latest inflation rates.
As indicated by the high p-values and low coefficients, inflation expectations were very firmly anchored between 1994 and 2012 before dipping, then reaffirmed in 2015 before weakening again by surprise prints in 2018.
The recent weakening compares to estimates seen in the move started in 2018, when expectations fell by 30 basis points. Though inflation surprises were much more extreme in size, the subsequent recalibration of expectations was proportional.
One likely reason for the gradual weakening of anchors since 2012 lies in the US Federal Reserve’s (Fed) balance sheet, which has become another variable for inflation considerations. Given its expansion to gargantuan size since the financial crisis, anchors may be recalibrated more frequently as the balance sheet shrinks.
On the basis of the proportional reaction of expectations up to surveys taken in the November 2021 for the fourth quarter, and our own view of inflation receding to more manageable levels towards the end of the year, the Fed should not need to rush rate rises. However, CPI continued to surprise to the upside, which may have added dynamic to the de-anchoring process.
A significant de-anchoring of expectations could lead to vastly different outcomes, depending on the stance the policymakers take. The central bank could reinforce the anchor with rigorous interventions. Alternatively, it may let inflation expectations, and realisations, spiral up before stepping on the monetary brakes.
It seems unlikely that the Fed will stand by and watch inflation get too out of hand. While many market participants, including the US Treasury, could profit from higher inflation, the prospect of runaway inflation that requires more abrupt stopping seems very unattractive.
So far, our focus has been on US inflation expectations. Surveys for long-term inflation expectations by the European Central Bank also show an upward shift in forecasts. For the eurozone, however, long-term expectations used to be anchored around 1.9%, then fell in 2019, before only returning to the old anchor value with the recent recalibration seen in many countries. For the UK, survey-based measures of inflation expectations by forecasters have risen, but not as dramatically as seen in America.
While some cost-push factors are global, the context in which these inflation surprises have come in is not. We have argued before that the US is leading this economic recovery, in part due to the aggressiveness of the monetary and fiscal stimulus in the pandemic. Growth tends to be slower in other developed markets. Therefore, domestic drivers of inflation are, like the recovery, building up more gradually.
Welcome to the March edition of "Market Perspectives", the monthly investment strategy update from Barclays Private Bank. In this month’s report, we look at just how likely a recession might be, and what it could mean for equities, bonds, and other asset classes.
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