Evening Brief – 04.25.23

For the most part, US inflation expectations moved in line with realized inflation, receiving little attention from investors. But the last two years have seen the most pronounced divergence since 1980, with backward CPI inflation spiking to a high of almost 9% year-over-year in the middle of 2022, even as expectations remained relatively subdued, with short-term inflation expectations climbing no higher than 4.3%.

Even though expectations and trailing inflation may diverge, and perhaps especially when they diverge, inflation expectations are important because they can, and do, affect realized inflation rates through their impact on consumer and investor behavior.

This is happening in two important ways: consumers are deferring big-ticket purchases and investors are allocating more assets to money market funds. Modest inflation expectations coupled with the inverted US yield curve mean money market funds look relatively attractive compared with mutual funds investing in riskier assets.

Currently, three-month US Treasury bills, deflated by short-term inflation expectations, deliver a real yield of almost 2%. In contrast, 10-year US Treasuries, deflated by long-term inflation expectations, deliver 1%.

These considerations have real-economy consequences. The flow from deposits to money market funds means less bank credit in the economy. And investors’ belief in disinflation, which means they are happy to hold money market funds instead of reaching for yield in riskier assets, equates to higher capital costs for risk-taking enterprises. Both point to reduced demand, and lower inflation.

There is a feedback loop from inflation expectations to the real economy, in which lower inflation expectations lead to reduced demand for consumer goods, capital goods and services. The risk is that this reduced demand leads to a recession.