Despite the surprisingly bad inflation print last week, the market has come to expect much less inflation over the next year. While longer-term inflation expectations in one year’s and five years' time (shown by FWD INFL 1x5Y and 5x5Y) remain low and well-anchored, anticipated inflation over the next twelve months based on bond prices has precipitously declined from over five percent to well under two. One potential reason is that an oncoming recession might seriously deflate prices, and quickly. But still – a recession is only somewhat more likely now than it was a few months ago, and the labor market will likely remain tight by historical standards even if growth slows, supporting higher inflation than we would like. The market is positioning itself to be surprised again by higher inflation, threatening illiquidity and volatility across the world’s most important debt markets. But the structural difference in views between the Fed and the market is interesting in itself: While the market expects a return to “divine-coincidence” policy, where stabilizing inflation would automatically stabilize output, the Fed might anticipate a more regionalized and commodity-strapped world shaped by supply, where efforts to stabilize inflation will create serious volatility in output and stressors in financial markets. The good days of the Great Moderation and divine coincidences might be ending, but the market seemingly doesn’t want to hear it.
Sources: Philipp Hildebrand from BlackRock; Jason Furman’s Twitter
Thomas Triedman, a sophomore at Yale, is a Summer 2022 Collegiate Associate at the Manhattan Institute
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