Reflecting on a Year of High Inflation
Around this time last year, the U.S. government’s revelation that the Consumer Price Index (CPI) surged to 9.06% in June 2022 sent shockwaves throughout financial circles. It marked the highest inflation rate since 1981 and painted a picture reminiscent of the 1970s wage-price spiral. The suggestion that only a severe recession could subdue such extreme inflation had many bracing for economic fallout.
Yet, in one corner of the vast $30 trillion U.S. government securities market, these warnings fell on deaf ears. This segment of the market, focused on derivatives, suggested a different narrative.
The Market’s Clairvoyance: Reading Between the Lines
Fast forward to today, the consensus is that the inflation rate for June has dropped to around 3%, something the derivatives market had predicted a year ago. These derivative tools, notably inflation swaps, demonstrated an unparalleled foresight. They accurately predicted a two-year inflation acceleration due to the Covid-19 pandemic’s global lockdown, followed by a sharp eight-year abatement.
Within the past 12 months, the inflation swaps market accurately foretold the CPI path with precision unmatched by any commentator, outshining the collective wisdom of economists and the critics of Fed Chair Jerome Powell and President Joe Biden.
Inflation Swaps: The Underrated Market Seer
Investors looking for a hedge against rising prices have traditionally turned to Treasury Inflation-Protected Securities (TIPS). However, inflation swaps, which offer more timely month-to-month data, emerged as a potent tool during the recent economic turbulence.
For the uninitiated, inflation swaps are financial agreements that allow one party to pay a fixed rate on a notional amount in exchange for a floating rate tied to an inflation gauge, such as the CPI.
A Historical Deep Dive: Swaps Predicting CPI
When the inflation scare was at its peak in 2022, the inflation swaps market correctly forecasted a CPI reading of 4% for May 2023, significantly less than the then-prevailing 8.6% level. This accurate prediction wasn’t an anomaly. As we moved closer to April’s CPI data release this year, inflation swaps were priced at 4.9%, mirroring the government’s published CPI. Similar precision was observed in March and February.
Anticipating June’s CPI Report
As we brace ourselves for the release of the June CPI report, the inflation swaps market estimates a CPI between 2% and 3.3%. Based on past trends, it’s likely the government will report a consumer price rise of approximately 3.03% from a year earlier. This would be nearly a percentage point lower than the previous month’s report.
It’s important to note that inflation swaps, despite commanding a smaller market volume than TIPS, have proven significantly accurate in forecasting inflation trends.
Rewriting the Inflation Narrative: Market versus Commentators
During the high inflation period, critics lambasted the Fed for delaying monetary policy tightening until March 2022. However, economists like Brad DeLong, a professor at the University of California at Berkeley, argued that the bond market’s inflation expectations might be more reliable than those driving the economy’s decisions.
David Wilcox, a former director of research and statistics at the Fed, questioned whether earlier action by the Fed could have significantly mitigated the pandemic-era inflation problem. A model developed by Bloomberg Economics suggested that even if the Fed had begun tightening nine months earlier, the inflation peak would have only reduced to 7.6% instead of 8.6%.
Meanwhile, inflation swaps have consistently proven more effective in predicting inflation than traditional methods, such as the University of Michigan’s monthly inflation survey and forecasts by economists.
The Road Ahead: What the Market Signals
Currently, the market predicts a gradual slowing in inflation to well below 3% over the next 12 months. Interestingly, many economists who argued that only a recession could tame inflation now suggest that the economy might dodge a downturn.
In the end, the unfolding narrative attests to the power of the market as a soothsayer, often providing insights with more accuracy and credibility than many expert commentators. In this drama of inflation, market predictions have proven time and again that they indeed “can’t make this stuff up.”
