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No supply shock in the equilibrium price

No supply shock in the equilibrium price

01.03.2020

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Home » Economics » No supply shock in the equilibrium price

No supply shock in the equilibrium price

01/03/2020 18:14:01
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Although it is early, the US bond market linked to inflation acts in a stereotypical way: underperforming nominal bonds in a rally. This is in line with the general rule that equilibrium inflation is directional: yields quoted on TIPS (real yields or indexed yields) move less than nominal yields. This may not be too surprising, but one would have expected that behavior would be different in the event of a supply shock.

(Context: breakeven inflation is the spread between a conventional (nominal) fixed coupon Treasury and an inflation-indexed bond (TIPS), where payments are indexed to inflation. I talk about this in my manual Balanced inflation analysis. This is equilibrium inflation because it is a very good approximation of the inflation rate required for the total return of inflation-linked bonds to balance with the conventional bond . Breakeven inflation is the best measure of market inflation expectations, although small gaps appear between breakeven inflation and inflation forecasts.)

The figure at the beginning of this article shows breakeven and forward inflation (based on data from the Federal Reserve H.15). Unsurprisingly, breakeven inflation forward is the most declining, as shorter breakeven are expected to be more sensitive to any price hikes in the short term due to supply chain disruptions .

The argument for the current trend is fairly plausible: disruptions in the supply chain are likely to be short-lived, while if there are bankruptcies by exposed entities, the world faces another deflationary slowdown. Meanwhile. post-crisis experience has disillusioned most market participants as to the effectiveness of monetary policy in stimulating the real economy. (Many investors are convinced that central bank intervention strengthens the risk asset markets.)

The obvious risk is that investors have fallen into the recency bias: they are setting aside the possibility of structural changes in the economy. Any move to reverse globalization would lead to inflationary pressures: the return of productive capacity to developed economies would increase price structures and boost workers’ prospects on the labor market. Betting on the reversal of globalization has been a loser in recent decades, so I certainly don’t expect such a result. That said, the insurance value of inflation-indexed bonds is probably worth a closer look if current trends continue.

(c) Brian Romanchuk 2020

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