Developments in U.S. Inflation

Talking with a range of market participants, we have been struck by the fact that the vast majority are very concerned about inflation in the United States. Leaving aside our usual arguments about the output gaps that will require a protracted period of above trend growth to close, there a several other considerations that may help ease inflation worries.

First, TIP funds, that is mutual funds that invest in the Treasury's Inflation Protected Securities, typically pay a quarterly dividend. At least one fund--Vanguard's Inflation-Protected Securities Fund (AUM ~ $21 billion) did not pay a dividend in late June. The dividend is derived from interest earned on the investments and an adjustment for inflation, based on CPI. Consumer prices have fallen in H1 2009 and by the most in half a century.

Second, and more importantly, wage pressures are nonexistent. Wages, as reported in the June employment report that was released last week, were unchanged and in Q2 had increased at a 0.7% annualized pace, the slowest pace since the time series began in 1964. Fed officials have thus far been fairly quiet on wage deflation, but it is likely to be increasingly worrisome as it has potential negative implications for consumption. Income levels have been bolstered by transfer payments, including cost-of-living adjustment for Social Security and the 1-off payment of $250 to every Social Security recipient,and payroll withholding tax cuts. The impact of these may fade as H2 unfolds. This warns that the biggest jump in the U.S. savings rate may be behind us and that consumption going forward be financed to a greater extent from savings.

Third, what concerns policy makers is not only actual inflation but inflation expectations. One way to measure inflation expectations, which both the Fed officials and ECB officials have cited is the five-year five year forward. Near term inflation expectations are noisy, but inflation expectations say for 2015-2020 are thought to be truer, less noisy or distorted. The U.S. 5-year 5-year forward has fallen from around 2.6% in late may to below 2.2% now. Inflation expectations sit just above the 100-day moving average (~2.07%). By comparison the French (proxy for the euro-zone) five-year five-year forward stands at 2.79% and the UK five-year five-year forward is at 3.94%.