Worried About Inflation? Where Will It Come From?

Where will inflation emerge? Most cyclical drivers of inflation are pointing lower.

Inflation is a tricky topic that often brings in many personal feelings or personal anecdotes about the rate of inflation experienced in everyday life. The problem is that this experience differs for every person depending on age, income bracket, where you live, what items you buy and more.

When measuring inflation expectations or analyzing the future trend in inflation, we should not be concerned with the inflation we see outside our window because that may or may not apply to the national average.

We should rather study the various channels that an inflationary spiral can emerge and try to find leading indicators from each of those areas.

If we cover all the main areas that an inflationary spiral can emerge, we can have a greater degree of confidence in the forecast.

Very often, specifically with respect to the bullish thesis on long-term bonds, I hear that "inflation is going to turn."

The logical follow-up question to this statement is "where?"

What area or channel will the inflation come from?

When studying history, there are a few main areas that we need to watch as it pertains to a cyclical change in inflation. The labor market, money supply, commodities, currencies, government spending, and import prices are all areas that inflation can emerge and we will look at most of those areas in this note.

Below is a chart of the 5-year breakeven inflation rate, or the market implied inflation rate over the next five years. As the chart shows, inflation expectations hit a peak around 2011-2012 but were generally elevated and trending higher from 2010-2013. Inflation expectations crashed from 2014-2016 before rebounding through 2018. As the chart below shows, inflation expectations are once again cycling lower. The path of inflation expectations for this economic cycle should be contextualized by some of the indicators below.

5 year breakeven
Source: Bloomberg

In no particular order, let's look at some of the areas mentioned above.

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