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Inflation Data May Continue to Surprise

William Hester, CFA
March 2006
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As the final fourth-quarter profit reports trickle in – and before a new earnings season dawns - investors will have to shift their focus toward other gauges of the potential for corporate progress. One area may be economic data, especially how new reports compare with what's expected.

In that sense, February was a reasonably good month. Economic data generally came in above expectations, reversing a trend of negative news that began in December. The best feel for these trends comes from tallying economic surprises – an approach inspired by Bridgewater Associates (www.bwater.com). By netting each day's announcements – results coming in above expectations get added while disappointments are subtracted – you get a sort of ‘advance-decline line' that provides a sense of the overall trend in economic releases. The chart below shows the Economic Surprise Index since the beginning of 2004.

The Surprise Index has been trending lower since the middle of 2004, except for bursts of positive surprises in November and December of 2004 and in November of 2005. The peak in the Surprise Index followed the late 2003 peak in the steepness of the yield curve. By way of a consistently flattening yield curve, markets have priced in lower growth expectations, and the data has mostly agreed.

The rise in the Surprise Index in February was fueled by both growth and inflation data. You can see this in the graph below where the indices that track growth and inflation are separated. They've generally been moving together, spiking last November and coming in below expectations up through the beginning of February, then rising near the end of the month.

The Implied Inflation Rate

After separating economic releases by whether they provide information about growth or inflation (or both), the next natural step is to look at the components of the Treasury yield that are influenced by each. The nominal Treasury yield is made up of a real yield and inflation expectations. Real yields represent the real cost of borrowing. In an economy without inflation, it's the rate which people decide whether they want to spend today, or save for tomorrow. It's partly influenced by the strength of the economy, the underlying productivity of businesses, and the expected returns on other investments. The inflation expectation component is the premium that investors add to the real yield to compensate themselves for the lost purchasing power of rising prices. (There is also a premium for the risk of getting the inflation forecast wrong, but it represents only a small part of the overall yield.)

Subtracting the yield on U.S. inflation-protected notes (TIPS) - a proxy for the real yield - from the yield on the nominal bond approximates the average rate of inflation investors expect over the term of the bond. The 10-year TIPS is currently yielding 2.05 percent, while 10-year nominal Treasuries are offering 4.65 percent, leaving an implied inflation rate of 2.6 percent.

Even though this spread is an inflation estimate over a decade, recent trends in price data can influence it. You can see this in the graph below which plots the Inflation Surprise Index versus the implied inflation rate. It looks much like you'd expect from a forward-looking bond market. The implied inflation rate leads the trend in surprises in economic releases.

By January of this year the spread between the implied inflation rate and the Inflation Surprise Index had been at one of its widest points in two years. The implied inflation rate tacked on nearly 30 basis points in January and February, while December and January inflation data came in mostly below expectations. In February that trend reversed. A majority of the inflation data either met expectations or exceeded them and the gap between the implied inflation rate and the Inflation Surprise Index began to close.

The current implied inflation rate sits slightly above the 2.5 percent that economists are forecasting over the next decade. This 10-year inflation forecast comes from the Philadelphia's Fed's Livingston Survey, a semi-annual poll of roughly 40 economists. In addition to asking what they expect inflation will be this year and next, they're also asked for a forecast for the CPI over the next decade. As you can see below, the implied inflation rate has mostly traded below the 10-year forecasts for inflation.

A few other points are worth highlighting. One is that the low level of implied inflation in the late 90's seems to have been the result of inflation-protected bonds being dramatically under-priced. This was partly from neglect. Individual investors shied away because of the tax treatment of the inflation adjustments. Institutional investors couldn't be bothered with a 4 percent yield when technology stocks were gaining 30 percent a year.

Since that time investors have become more comfortable with TIPS and trading liquidity has improved. And, as you can see in the graph, over the past two years the implied inflation rate has traded in a range around economist's long-term inflation forecasts. The implied inflation rate now sits above the long-term forecast, the first time since October that this has happened. It will be interesting to see if these long-term forecasts continue to cut through the center of the variability in the implied inflation premium.

Inflation Surprises

The inflation debate will not be won with the data currently in hand. That's because there is data to support both sides of the discussion. The graph below shows the Inflation Surprise Index split into two components. One is an index that tracks consumer and producer inflation that includes food and energy. The second is an index that tracks core inflation.

For about a year now economists have been consistently overestimating core inflation, while dependably underestimating over-all inflation. The markets may become more sensitive to inflation data if the core inflation data were to begin to surprise on the upside.

None of this means that inflation needs to rise quickly or stubbornly. But the bond market's implied inflation rate has recently done a good job of leading the direction of inflation surprises. If the implied inflation rate continues to increase, the number of inflation surprises may do the same.


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