Bond Economics: Inflation: Paint Drying &c

A weak August PPI report today continues the narrative that inflation in the United States is a nothingburger. If I were attempting to be a forecaster, I could have easily been wildly wrong in my inflation prognostications (although the previous chickening out on mega-tariffs meant that my initial reactions would have to have been revised).

As always, there are anecdotal price pressures in the PPI (47.2% annual increase in turkey prices! (link to table)), but the overall final demand figure was low (down 0.1% seasonally adjusted on the month).

The inflation risk from tariffs is a “one-off price level shift” that creates some second-order effects. Since the economy is now driven by services, the magnitude of the price shock is going to be less than what we saw in the COVID fallout, as the labour market tightened in that episode. The labour market is the most important market in the economy, and wage hikes will most likely necessitate broad-based price hikes to preserve profit margins, while the higher wages goose final demand. A tariff hike is a tax that drains income from the private sector. The chilling effect of immigration actions would possibly pose more enduring inflation risks.

The TIPS market is entirely reasonable with its sanguine pricing (figure at top of article). Spot breakeven inflation rates have not appreciably moved after mid-2022, and the same is true for the 5-year, 5-year forward. (I do not normally track front end breakeven rates that would pick up near-term risks since they can be very sensitive to pricing details.)

Explanatory note: the breakeven inflation rate is the future rate of inflation required for an inflation-linked bond — like TIPS — to have the same return as corresponding maturity conventional (nominal) bond. In pricing theory, the breakeven rate is the mathematically expected inflation rate implied by the market (assuming risk neutrality), but “expected inflation” is not necessarily the same thing as “forecast inflation.” I discuss inflation-linked bonds in my book Inflation-Linked Analysis.

The lack of significant movement in breakeven inflation rates probably masks the potential dispersion of outcomes. If tariffs are allowed to significantly bite without being rolled back, then recession risks cancel the short-term price rise risks.

Arguably, the benign readings in the inflation-linked market and economic data does give cover for Fed rate cuts. The political interaction of rate cuts and anecdotal price rises (have fun turkey shopping on Thanksgiving!) would certainly be interesting.

The only interesting long-term concern is the possibility that President Trump pushes for a “dash for growth” Federal Reserve with ultra-low interest rate policies. This might panic some sectors of the fixed income market, but given the importance of the hard money clique in the Republican Party, it is hard to see how a pro-inflation Fed is sustainable.

Sigh, the Russians Are At It Again

The Russians clearly are testing the bounds of what is possible by sending a wave of drones at Poland overnight. The rapid implosion of the credibility of American security guarantees are dangerous, but at the same time, the Russian military has been hollowed out by years of attrition in Ukraine. This is probably more of a signal of support for pro-Russian parties in Western Europe, and so I would not be ringing the geopolitical risk alarm bell yet.