On inflation and inflation expectations

Rampant inflation continues to etch worry lines onto the foreheads of consumers and investors as the latter watch the purchasing power of their assets rapidly get eroded. However, temporarily skyrocketing inflation rates should not be projected into the future. Market- and survey-based inflation expectations are still well-anchored and give reason to anticipate that real returns will stay positive in the long run.

Inflation and real return

High, higher – inflation has been trending ever upward in recent months, shooting past analysts’ and central banks’ expectations with uncanny regularity. Inflation is relevant not just for weekly shopping trips to the supermarket or for your next energy bill, but also has to be taken into account in financial investments. Because if an investor’s objective is to at least preserve or even increase the real purchasing power of his or her assets, then the return on his or her portfolio must (at the least) exceed the rate of inflation. But what inflation rate should be factored into one’s reasoning? It would be a mistake, in any case, to extrapolate the current record-high inflation numbers into the future. Diagrams that subtract inflation from a current bond yield or a projected stock-market return and accordingly imply a deeply negative real return are therefore misleading even though they regularly get published in the (social) media. That’s because the annual inflation rate, which compares the current price of a basket of goods with its price twelve months ago, is not a good indicator of actual future inflation, especially not in times of temporarily skyrocketing inflation. This is evidenced by a look at the past in both the USA and Europe. In the early 1990s, peak annual inflation rates of 6.3% in the USA, 6.2% in Germany and 6.6% in Switzerland were actually followed by a decade of much lower inflation in those countries averaging out to 2.9%, 2.2% and 1.7%, respectively. The last inflation peak in 2007/2008 reveals a similar picture: a pinnacle of 5.6%, 3.2% and 3.1%, respectively, in the USA, Germany and Switzerland was followed by average annual inflation readings of 1.6%, 1.3% and 0% for the next ten years. Realizable returns for an investor in the corresponding equity markets (as represented by the S&P 500, DAX, SMI indices) were thus consistently well in positive territory in both nominal and real terms over a ten-year period. The USA’s S&P 500 index, for example, delivered an average annual nominal return of approximately 11.2% and an average yearly real return of around 9.6% for the period from July 2008 to July 2018 (far outpacing the peak inflation rate of 5.6%). It therefore makes little sense also today to use the currently observable inflation rates of close to 10% (except in Switzerland) as a basis for deriving real return expectations for individual asset classes or a mixed portfolio.

On the brink of the next peak | No good input for return projections

Inflation and 10-year average annual return; example: USA

Sources: Bloomberg, Kaiser Partner Privatbank

The better alternative(s)

But what other ways are there to come up with the “right” (long-term) inflation expectation for a long investment horizon and a corresponding long-term expected return forecast? One way is to use complex statistical models with a multitude of (economic) variables to compute an inflation forecast. The computing power of today’s computers places practically no limits on what you can do here. However, high complexity doesn’t necessarily guarantee better or more accurate results. According to a working paper from the European Central Bank¹, market- and survey-based measures for estimating inflation expectations have significantly greater reliability and superior predictive power. Survey-based inflation expectations can be derived from polls of financial experts or consumers. The Survey of Professional Forecasters, which was initiated in the USA in 1968 and has been conducted on a quarterly basis by the Federal Reserve Bank of Philadelphia since 1990, is considered to be arguably the oldest regularly conducted poll of macroeconomists. The ECB has been conducting a similar survey of financial pros for the Eurozone in the same rhythm since 1999. Looking at the surveys conducted by the world’s two biggest central banks in the second quarter of 2022, one notices a striking difference between financial experts’ long-term inflation expectations and the nearly double-digit current inflation rates in the USA and the Eurozone. According to those surveys, an average annual inflation rate of 3.1% is expected in the USA over the next five years (compared to the June reading of 9.1%) and a rate of 2.1% is expected for the Eurozone over the next four years (compared to the latest reading of 8.1%). The ECB working paper cited above attests good informative value and predictive power to the Survey of Professional Forecasters inflation poll. Its drawback, though, is its low frequency with just four data points per year.

An even better alternative way to derive inflation expectations is to use market-based measures to do so. Five-year, five-year (5y5y) inflation swaps have established themselves as a benchmark here. This measure first gained widespread attention at the annual meeting of central bankers in Jackson Hole in 2014, when then-ECB President Mario Draghi explicitly cited the overly low 5y5y inflation swap rate as a reason for the subsequent easing of monetary policy. The 5y5y inflation swap rate expresses the financial markets’ estimate of expected average inflation over the five-year period that begins five years from today. It is derived from five-year and ten-year inflation futures. The 5y5y inflation swap rate is thus based on actual transactions, reflects market participants’ expectations “in real time” and is available on a daily basis. Current 5y5y inflation swap rates place long-term inflation expectations at around 2.5% for the USA and at approximately 2% for the Eurozone. Although those figures have risen significantly since the coronavirus shock in March 2020, they are only slightly above the average for the last ten years. Moreover, near-term inflation expectations have moderated a bit as a result of the recent pullback in commodity prices and in view of slowing economic activity. They at least remain in a comfortable and familiar range from an investor’s perspective. They, last but not least, thus also inspire confidence that a positive real return can continue to be earned over the next five or ten years with a well-thought-out investment strategy.

In familiar climes | Market-based inflation expectations are (still) well-anchored

5y5y inflation swap rates

Sources: Bloomberg, Kaiser Partner Privatbank

¹ECB Working Paper #1865: “Inflation forecasts: Are market-based and survey-based measures informative?”