Current market inflation expectations are ridiculous

I think core inflation will reaccelerate after falling to around 2%.

March 2024, From the Field

 

Key Insights

  • My view is that core inflation will fall to around 2%. My longer-term outlook is not as sanguine, however, as I think inflation will reaccelerate.
  • Though artificial intelligence (AI) is a long-run productivity miracle, I see AI being inflationary in the short term as implementation will take time and labor.
  • China is a wild card for inflation. An increase in Chinese domestic demand would drive export prices higher, pressuring inflation up for its trading partners.

 

Written by

Arif Husain Head of Fixed Income and Chief Investment Officer, Fixed Income


 


 

Raise your hand if you honestly thought year-over-year U.S. headline consumer price index (CPI) inflation would peak in June 2022 at 9.1% and stay above 6% into early 2023. I expect to see very few hands—forecasts for inflation from 2021 through 2023 were wildly inaccurate. Even many central bankers and most economists got it wrong and were forced to rethink long-standing assumptions about inflation. Put your hand down if you even whispered “transitory.”

Breakeven spreads—the market’s best measure of expected headline inflation—on U.S. Treasury inflation protected securities (TIPS) ranged between 2.44% (five year) and 2.28% (30 year) in mid-March 2024.1In the context of the inflation volatility experienced since 2020, this appears utterly ridiculous. You’d expect at least modest variation in inflation expectations across maturities given how much headline CPI inflation has fluctuated over the last few years. Does this mean that market participants have no idea where inflation will settle? Or are they seeing inflation miraculously disappearing?

Will the downward trend in inflation continue?

Market views on the path of inflation are currently not nearly as divergent as they were in 2021 and early 2022, when outlooks were divided into “transitory” (which included most developed market central banks) and “persistent” camps. Of course, inflation broadly trended downward as 2023 progressed. Most commentators think this will continue through 2024, allowing the Federal Reserve and other central banks to begin cutting interest rates at some point during the year.

But early 2024 has featured signs that the global economy isn’t decelerating nearly as quickly as anticipated, stoking concerns that inflationary forces could build once again. Case in point: Portions of the U.S. CPI numbers for January and February were higher than expected, and January’s nonfarm payrolls report blew past consensus expectations for jobs added (though the jobs-added number was later revised lower).

Inflation to reaccelerate after nearing Fed target

My view is that core inflation will fall to around 2%, which is the target for several central banks, including the Fed and the European Central Bank. My longer-term outlook is not as sanguine, however, as I think inflation will reaccelerate.

Artificial intelligence (AI) is a productivity miracle, at least in the longer run. But implementing AI into corporate processes across the manufacturing and services sectors will take time and more labor, imposing higher costs. As a result, I see AI being inflationary in the short term before the economy can realize its longer-term productivity benefits. Much of the anecdotal evidence our analysts pick up in their hundreds of company meetings confirm this view.

China is another wild card for inflation. Faltering Chinese domestic demand has meant that the country has been exporting goods disinflation (or even deflation, in some cases) through global trade. This has been a major contributor to decelerating price pressures worldwide.

However, an increase in demand within China—potentially triggered by fiscal stimulus funded by the country’s recently announced special issue of new long-term government bonds—would reverse that factor and drive export prices higher. While this probably isn’t a baseline scenario, the main point here is that sentiment toward China is skewed to the downside. A surprise would likely be to the upside. Then consider the potential inflationary impact of any additional tariffs that may result from the developing U.S. political theater, and you have clear inflationary risk.

Collaboration among colleagues with different views is a hallmark of TRPA’s2 investment process. While I am wary of the risks that inflation could reaccelerate, there is research that serves to temper these expectations. Blerina Uruçi, our chief U.S. economist in the Fixed Income Division, has a more benign outlook for longer-run inflation.

Tempered expectations: The potential for a more benign inflation outlook

Historically, it has been impossible to bring inflation down rapidly without a recession or a large negative shock to the labor market, which is why I expect that the road toward 2% inflation will be long and winding. Nevertheless, demand for workers has slowed significantly from last year, and I expect that this will continue to ease some of the labor market pressures on inflation and help in bringing it down to the Fed’s target, likely by early 2025.

Focus on shelter inflation and its lagged effects

Shelter (or housing costs) is a large component of inflation, making up around 30% of the consumer price index, and further progress in bringing down rent inflation will be necessary to ensure that U.S. inflation continues to move closer to the Fed’s target. CPI measures of shelter respond with long lags to more timely measures of home prices and market rents. Research suggests these lags can be longer than a year. If you look at private sector data on rents and home prices, they signal that rent inflation should decline further. 

The real question is the speed at which this will occur. This, of course, is difficult to answer. Some models using private sector home value and rent indexes suggest we could see sticky shelter inflation holding above 4% for 2024, which would imply a much slower glide down to 2% for overall inflation.

– Blerina Uruçi, Chief U.S. Economist

While I think that the environment is conducive to a reacceleration in inflation, I’m keeping Blerina’s inflation outlook in mind and continuing to monitor the potential for inflation to maintain its downward course. I’m confident that this type of collaboration and consideration of differing views can lead to better investment decisions from our portfolio managers.

From the Field

Central bank rate-cut pricing is eye-catching but deceiving

The large number of priced-in 2024 rate cuts is an average of expectations across many outcomes.

Data source: Bloomberg Finance LP.
T. Rowe Price Associates, Inc. (TRPA).
The views expressed are those of the author as of the date indicate and are subject to change. These views may differ significantly from other associates and/or T. Rowe Price group companies. T. Rowe Price assumes no duty to and does not undertake to update the views expressed.
T. Rowe Price cautions that economic estimates and forward-looking statements are subject to numerous assumptions, risks, and uncertainties, which change over time. Actual outcomes could differ materially from those anticipated in estimates and forward‑looking statements, and future results could differ materially from historical outcomes. The information presented herein is shown for illustrative, informational purposes only. Any historical data used as a basis for analysis are based on information gathered by T. Rowe Price and from third-party sources and have not been verified. Forecasts are based on subjective estimates about market environments that may never occur. Any forward-looking statements speak only as of the date they are made. T. Rowe Price assumes no duty to, and does not undertake to, update forward-looking statements.

Important Information

This material is being furnished for general informational and/or marketing purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, nor is it intended to serve as the primary basis for an investment decision. Prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request. It is not intended for distribution to retail investors in any jurisdiction.

Australia—Issued by T. Rowe Price Australia Limited (ABN: 13 620 668 895 and AFSL: 503741), Level 28, Governor Phillip Tower, 1 Farrer Place, Sydney NSW 2000, Australia. For Wholesale Clients only.

Canada—Issued in Canada by T. Rowe Price (Canada), Inc. T. Rowe Price (Canada), Inc.’s investment management services are only available to Accredited Investors as defined under National Instrument 45-106. T. Rowe Price (Canada), Inc. enters into written delegation agreements with affiliates to provide investment management services.

EEA—Unless indicated otherwise this material is issued and approved by T. Rowe Price (Luxembourg) Management S.à r.l. 35 Boulevard du Prince Henri L-1724 Luxembourg which is authorised and regulated by the Luxembourg Commission de Surveillance du Secteur Financier. For Professional Clients only.

New Zealand—Issued by T. Rowe Price Australia Limited (ABN: 13 620 668 895 and AFSL: 503741), Level 28, Governor Phillip Tower, 1 Farrer Place, Sydney NSW 2000, Australia. No Interests are offered to the public. Accordingly, the Interests may not, directly or indirectly, be offered, sold or delivered in New Zealand, nor may any offering document or advertisement in relation to any offer of the Interests be distributed in New Zealand, other than in circumstances where there is no contravention of the Financial Markets Conduct Act 2013.

Switzerland—Issued in Switzerland by T. Rowe Price (Switzerland) GmbH, Talstrasse 65, 6th Floor, 8001 Zurich, Switzerland. For Qualified Investors only.

UK—This material is issued and approved by T. Rowe Price International Ltd, Warwick Court, 5 Paternoster Square, London EC4M 7DX which is authorised and regulated by the UK Financial Conduct Authority. For Professional Clients only.

© 2024 T. Rowe Price. All Rights Reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, and the Bighorn Sheep design are, collectively and/or apart, trademarks of T. Rowe Price Group, Inc.

ID0006871 (03/2024)
202403-3454610