The Enigma and Intangibility of Inflation

Apr 19, 2021

In Edwin A. Abbott’s book Flatland, a square, living on a plane called Flatland, attempts to grapple with the entrance of a three-dimensional sphere into its two-dimensional world (the square can only see an ever-changing slice of the sphere). The two-dimensional world simply does not allow – indeed, cannot allow - the square to appreciate the full structure of the three-dimensional sphere; it being able to only see from the perspective of two axes at any point. Thus, the square cannot even comprehend the existence of a sphere until it is taken to “Lineland” (a world within a line) and “Pointland” (a world within a single point), where it witnesses how the one-dimensional inhabitants of those worlds cannot comprehend the existence of a two-dimensional square.

From a Study of Space, to One of Time and Prices

In some respects, the Consumer Price Index (CPI) is a marvelous construct, giving us additional dimensions with which to observe the phenomenon of “prices.” A single price at one point in time would be of little use in forming conclusions without some context and perspective about how that price came to be. The CPI is almost like being able to reach into a price point and pull out a line - a time series no less, with which to make historical comparisons. The visibility we have into the basket of goods and services making up that time series is like having the perspective of yet another dimension - the composition of consumption over time. But occasionally, as useful as these data sets are, they still come one dimension short of being able to show a complete picture of prices in a multi-dimensional world. Inflation - the trajectory of prices - is one area where it has become increasingly important to recognize the merits and shortcomings of our measurement tools, so as to make more accurate conclusions about the state of the economy.

The second quarter of 2021, the months of April through June, will mark the one-year anniversary of the economic trough of the Covid crisis. The resulting “peak base effects” (distortions in prior periods that influence period-to-period comparisons) will likely give inflation doomsayers their strongest ammunition yet in calling for runaway inflation. In fact, year-over-year changes in prices will spike to new local highs this spring and summer, probably even exceeding 3%, or well above the Federal Reserve’s (Fed) 2% inflation target (although Core measures of inflation will likely be lower).

But as quickly as they arrive, those same base effects will start working in the opposite direction, allowing the Fed to describe the inflation spike as “transitory.” More interestingly will be how policymakers approach the future path of monetary policy in light of almost-certain high inflation prints this summer, followed by almost-certain declines over the 12 months that follow, back toward 2%, or below. Under an Average Inflation Targeting (AIT) framework, should this trajectory in the general price levels play out, we would not have observed the sustained price increases necessary for the Fed to remove emergency accommodation.

But are prices really languishing in the state of emergency that the posture of monetary policy suggests? Perhaps not, if dimensions beyond the CPI are a consideration.

What Financial Assets and Real Estate Tell Us About Inflation

Financial asset prices, which (rightly) do not have a home in the inflation consumption basket, are certainly not indicating deflation. This year corporate earnings are expected to exceed 2019 levels, and equity prices, which are up about 50% over the last year (using the S&P 500 Index as a gauge), are suggesting that corporate pricing power has emerged from the pandemic largely unscathed (if not stronger). The bond market concurs: 5-year U.S. inflation breakevens, one way of measuring the market’s expectation of forward inflation, currently reside at 2.6%, well above both their 2018 high and the Fed’s 2% inflation target. Financial assets are not consumed, in the traditional sense of the word, by the majority of the population, and can be quite volatile, hence are by no means the embodiment of the inflation to the consumer that traditional consumption baskets attempt to capture; nonetheless their signal value about the state of the economy should not be ignored.

The housing sector is a far more influential force on the economy than are financial assets (home ownership rates are triple that of equity ownership), and yet in aggregate homes are also enjoying similarly robust price appreciation. A majority of the population are homeowners, and we have written about consumer preference having shifted, as a result of the pandemic, toward non-urban ownership rather than urban rentals (see our recent piece In Unprecedented Times, Don’t Rely on (Obvious) Precedent). National house prices are up 17% over the last year, according to Bloomberg data (as of April 12, 2021), even as rents in large urban centers like New York are down (but clawing their way back as vaccination rates rise). So, while urban rental markets are important, they should not dictate monetary policy at the aggregate level, especially since the causes of price weakness in the markets in question have been extremely well telegraphed: social distance.

But perhaps the greatest dimensional change of all has been our consumption of data, both in terms of information, and the volume of bits and bytes by which that information is transferred. The digital age has created whole new categories of consumption that are becoming increasingly difficult to price. Data, for example, appears in many cases to be offered and consumed freely, but there are undoubtedly costs and benefits to these exchanges of data, as evidenced by the expenses and cash flows generated by the corporations who have invested in these intangible assets. Concepts like paywalls make inflation extremely difficult to calculate, because rather than the traditional economics of producing goods or services at a marginal cost in line with marginal demand, so much of future consumption in the digital space has already been produced, and simply lies waiting in cyberspace for a consumer to upgrade their service in order to access it (video streaming being a prime example).

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Toward a Three-Dimensional Fed Policy on Inflation?

Just as the two dimensions of Flatland were infinitely more instructive than zero-dimensional Pointland, or one-dimensional Lineland, yet still unable to provide the perspective needed to visualize a three-dimensional sphere, so the CPI has its limitations in allowing us a perfect view of prices. “Engineering inflation” may be as difficult as combating such structural forces like technology, globalization, oil production and ageing demographics (as we described in The Monetary Policy Endgame). And as the nature of commerce and consumer preferences change faster than the CPI can evolve, the concept of inflation is going to increasingly feel intangible, as though our ability to fully grasp it lies just beyond another paywall.

Having successfully steered the economy away from a deflationary abyss, the Fed must consider all available signals of prices to gauge what an appropriate speed limit would be for the economy (we think they will), and hence how much pressure to apply to the policy gas pedal. One way of evolving policy in recognition of rapidly improving economic fundamentals (especially on the employment front), while staying supportive of inflation expectations, and without allowing excessive volatility into the risk-free market, might be through a “monetary policy barbell strategy.” By tightening policy at the front-end of the yield curve (by bringing the Fed Funds rate modestly higher and reducing front end quantitative easing, or QE) while keeping generous accommodation in longer tenors (by keeping QE large, flexible, and reflexive at the 5- to 30-year points of the curve), the Fed could effectively maintain a form of yield curve control that would simultaneously acknowledge rapidly accelerating growth while keeping long term borrowing costs stable.

That stability at the long end of the curve would allow for accelerating investment, both private, but especially public, to continue extending the lifespan of the current expansion. The Fed can credibly acknowledge that if the prices of tangible consumption baskets simply aren’t as reflective of modern consumption as they used to be, then inflation for inflation’s sake need not be relied on too heavily as an economic speedometer.

Rick Rieder
Rick Rieder
Rick Rieder, Managing Director, is BlackRock’s Chief Investment Officer of Global Fixed Income and is Head of the Global Allocation Investment Team.
Russell Brownback
Managing Director
Russell Brownback, Managing Director, is Head of Global Macro positioning for Fixed Income.
Trevor Slaven
Managing Director
Trevor Slaven, Managing Director, is a portfolio manager on BlackRock’s Global Fixed Income team and is also the Head of Macro Research for Fundamental ...
Navin Saigal
Director
Navin Saigal, Director, is a portfolio manager and research analyst in the Office of the CIO of Global Fixed Income, and he serves as Chief Macro Content Of ...
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