No number is more important for investors right now than inflation. The belief that it will continue to rise underpins the recent rally in financial stocks and the slump in government bonds. It is key to commodities, currencies and more.
Yet investors are in a quandary: Theories used to forecast it just don't seem to work.
"I don't think we know what inflation is. It takes so many different forms," said David Lafferty, chief strategist at Natixis Global Asset Management, which manages about $900 billion. Inflation is this year's "wild card," Mr. Lafferty said.
For decades, the assumption has been that central banks have the ultimate handle on inflation. When inflation goes up, they raise interest rates to quell it; when it goes down, they lower the rates.
Investors care a lot, because bond yields broadly track interest rates. They need to predict inflation levels as well as how central banks would react.
Neither is easy, and it just got more complicated: After years of postcrisis monetary experimentation, it's not even clear central bankers can do much about inflation at all.
On Friday, five top economists presented a paper at a monetary-policy conference saying the main gauges policy makers typically use to understand inflation -- such as "slack" in the labor market -- don't actually explain it.
What's more, the last several years of extraordinary monetary policy have shaken a theory that had held sway for decades in financial markets: American economist Milton Friedman's view that inflation is ultimately a function of how much money a central bank prints.
That theory posits that if the economy has only two cars and two dollars, each car has to be worth $1. When the central bank issues two more dollars, there's suddenly $2 for every car: inflation. And what people think inflation will be in the future is crucial: Workers will bargain harder for pay raises if they believe prices will rise faster in the years to come.
Yet, after the 2008 crisis hit, central banks in developed economies slashed interest rates and printed trillions of dollars, euros, pounds and yen. Many investors and policy makers believed inflation -- and a selloff of government bonds -- would soon follow.
"I thought we'd see inflation before authorities could respond," said James Athey, a fund manager at Aberdeen Asset Management. So confident was one former eurozone central-bank governor that, over dinner in late 2013, he made a 10 Hong Kong dollar bet (pegged by the government at $1.29) with economics professor Ken Kuttner that money printing would cause inflation to soar.
It didn't. In fact, economists who study central-bank operations broadly believe that the amount of money created is a consequence of rising prices, not the cause. That is, if the price of cars goes from $1 to $2, the central bank will eventually need to issue more money to prevent money from getting scarce and interest rates from skyrocketing.
"I think I can count those 10 Hong Kong dollars as money in the bank," said Mr. Kuttner, of Williams College.
Mr. Athey laments not having bet heavily on U.S. Treasury bonds, which have been on a roll since 2008. "The bond investor community in aggregate for a long time got that wrong."
Friday's research also found little connection between people's expectations of future inflation and what prices actually turn out to be....MORE
Wednesday, March 8, 2017
"Everything the Market Thinks About Inflation Might Be Wrong"
From Dow Jones via Morningstar: