The 10-year breakeven inflation rate, a market-based measure of inflation expectations, hit its highest level last Friday, February 5, since 2014. Still, at 2.21% expected annual inflation over the next 10 years, it remains a relatively tame number, sitting a little above the Federal Reserve’s (Fed) 2% target. As shown in the LPL Chart of the Day, the 10-year breakeven inflation rate is near the very top of its range going back to mid-2013. Looking back further, even early in the last expansion breakeven expectations never rose above 2.7%.
“We may see inflation rates we haven’t seen in decades over the next year,” said LPL Financial Chief Market Strategist Ryan Detrick, “but that may not mean much. Core inflation hasn’t hit 3% since 1995 and it’s unlikely to even push that high for any extended period.”
Inflation prospects have become the subject of increasingly heated debate, as market participants try to gauge the impact of loose monetary policy and historic levels of fiscal stimulus, with even more on the way. Inflation has remained stubbornly below central bank targets for some time, and changes in the Fed’s policy framework, announced last year, indicate that the Fed believes those dynamics are here to stay. Still, there are legitimate forces in play on both sides of the debate—the question is how they balance out.
Forces Pushing Inflation Higher
- Improving economic outlook with potentially strong pent up demand
- Additional stimulus that may be spent rather than saved
- High savings rate
- Potentially weaker dollar
- Increase in commodity prices, which may flow into higher consumer prices
Forces Limiting Inflation
- Long-term headwinds from demographics, technology, and globalization
- Spare industrial capacity and slack in the labor market
- Long-term economic damage from the pandemic and associated recession
- Slower-than-historical long-term baseline for economic growth
While the temporary factors favoring inflation will hold some sway in 2021, and possibly even 2022, we believe structural forces will continue to limit the long-term inflation outlook. We may see core inflation (the Consumer Price Index excluding food and energy) rising above 2.5% for the trailing twelve months in the middle of 2021 as March, April, and May 2020, all deflationary months, roll off the trailing year numbers, but we expect core inflation to settle back into the 2–2.5% range by the end of the year. Even that level would be elevated compared to the last economic cycle, which averaged about 1.8% core inflation, and would be enough to push the 10-year Treasury yield up from its current level, but we do not believe it would not be enough to create any significant added economic risks.
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