Why Inflation Fears Threaten Our Economy
Inflation is now the biggest fear of large money managers.
According to Bank of America analysts, inflation displaced the COVID-19 pandemic as their biggest worry in March.
A recent survey noted that “93% of fund managers expect higher inflation in the next 12 months, up 7% from the prior month’s survey and an all-time high.” The bank began tracking managers’ biggest worries in 2011.
Large investors have focused on a variety of concerns in the last decade. Fears of a European debt crisis gave way to worries about China, a trade war, the 2020 presidential election and other stories that failed to crash the market.
But inflation is different. In many ways, fears of inflation can become a self-fulfilling prophecy.
How Inflation Expectations Become Reality
Economists have long noted a relationship between future expectations of inflation and the actual level of inflation.
The chart below shows that future expectations (the blue line) closely track the actual rate of inflation (the red line).
Inflation Expectations vs. Actual Inflation
(Source: Federal Reserve.)
This relationship was stronger before the Federal Reserve instituted quantitative easing in 2009. Since then, expectations have been steady while realized inflation was low.
Economists explain that under normal economic conditions:
Inflation expectations are simply the rate at which people — consumers, businesses, investors — expect prices to rise in the future. They matter because actual inflation depends, in part, on what we expect it to be. If everyone expects prices to rise, say, 3% over the next year, businesses will want to raise prices by (at least) 3%, and workers and their unions will want similar-sized raises. All else equal, if inflation expectations rise by 1%, actual inflation will tend to rise by 1% as well.
The Fed broke this link in 2009. If inflation increases, then consumers might panic. If they react as they did before 2009, then inflation could be locked in for the next year.
Inflation would force the Fed to raise rates. This could lead to a second recession and higher unemployment. That could also crash the stock market.
How we handle inflation fears will determine how high inflation goes. As the economy reopens, we need to watch inflation expectations. Institutional investors will be doing the same.
Editor, One Trade