Why Markets Shrugged Off Bad Inflation News
By Paul Krugman
Credit...John Minchillo/Associated PressAnother month, another bad consumer price report.
Media headlines screamed about 9.1 percent inflation, and the numbers for June were, in fact, bad no matter how you cut them.
Financial markets, however, largely shrugged off Wednesday’s news.
True, short-term interest rates rose, because given that hot inflation number it has become nearly certain that the Federal Reserve will go big on the next few interest rate hikes.
Longer-term rates, however, have barely budged: The five-year interest rate rose only 0.01 percentage points on Wednesday and 0.04 points on Thursday, while the 10-year rate, after a dip and a rise, ended Thursday where it had begun on Wednesday.
And no, the Fed isn’t keeping interest rates artificially low by buying lots of government bonds, which is something I keep hearing.
Actually, the Fed has started to shrink its balance sheet.
Why are markets so relaxed?
Because they appear to believe that the worst is behind us, that inflation is about to come down sharply.
And it’s helpful to understand the roots of that serenity.
Obligatory disclaimers: Markets can and often do get things very wrong (last fall they thought each Bitcoin was worth almost $70,000).
And for the past year and a half, inflation optimists, myself included, have been consistently behind the curve.
But the markets’ belief that the worst is behind us is based on a lot more than mere wishful thinking, and it’s worth going through the main points.
Notice that I’m mainly trying to explain what other people are thinking, rather than to persuade you that this time I personally have it right.
So, about the markets’ inflation expectations: We can measure those more or less directly.
The U.S. government issues “inflation-protected securities,” bonds whose principal is adjusted to compensate for changes in the Consumer Price Index.
Investors are willing to accept lower interest in return for this protection; in fact, the interest rate on an inflation-protected bond coming due a year from now is actually negative, -0.33 percent as I write this.
Ordinary, unprotected bonds coming due a year from now yield a bit more than 3.2 percent.
The difference between those yields — about 3.6 percentage points — is an implicit forecast of inflation over the next year.
That’s still too high for comfort, but it’s way down from recent numbers.
And Wednesday’s inflation report caused the five-year breakeven inflation rate — a medium-term number based on similar comparisons — to rise from 2.50 to … 2.51.
Why do markets expect inflation to come down so much?
First, rising gasoline prices were a big driver of June’s inflation number, but that’s already old news.
Prices at the pump have declined around 40 cents a gallon since their peak this year; and since wholesale gasoline prices are down by more than a dollar, there’s every reason to believe that this decline will continue for a while.
There are a bunch of other factors that should dampen inflation but aren’t yet reflected in government reports.
Official estimates of housing costs tend to lag well behind listed rents, so they’re only now capturing the big surge in 2021 and won’t reflect moderating rents for a while.
Shipping costs are down, and, in general, supply-chain problems seem to be easing.
So we ought to be getting some short-term inflation relief, starting more or less now.
And there are two big reasons to expect the coming inflation slowdown to persist.
First, while we keep hearing ominous warnings about a wage-price spiral, that’s hard to manage if, well, wages refuse to spiral.
And the rate of growth in average wages has actually been slowing, from around 6 percent at the beginning of this year to around 4 percent now.
That’s still somewhat too high to be consistent with the Fed’s target of 2 percent inflation, but not by a lot.
Second, while the Fed is trying to fight inflation by raising interest rates, we shouldn’t expect to be seeing much, if any, payoff to this effort just yet.
Long-term interest rates, which are what matter for the real economy and reflect both current Fed policy and expectations about future policy, didn’t really take off until March.
And nobody, but nobody, should have believed that this rate rise would have a noticeable effect on inflation in a scant three to four months.
That is, if the Fed’s change in policy is going to bring inflation down, that’s all going to happen in the future.
The markets think the Fed will contain inflation, and so do I; but June’s consumer price report tells you nothing, one way or the other, about whether we’re right.
It’s just too soon.
So the message we’re getting from the markets — a message backed by a lot of data that hasn’t yet made it into official consumer price numbers — is, don’t panic.
Inflation is not, in fact, out of control, though the pain many consumers are feeling right now is.
Unfortunately, not panicking is going to be hard advice for the Fed to take.
I’m sure Fed officials understand the arguments I’ve just made, and many of them probably agree.
But they’re under a lot of pressure from peddlers of inflation panic, empowered both by recent numbers and by the Fed’s bad calls last year.
As a result, the biggest thing we currently have to fear is fear itself — that the Fed will let itself be bullied into hiking rates too much and produce a gratuitous recession.
Paul Krugman has been an Opinion columnist since 2000 and is also a distinguished professor at the City University of New York Graduate Center. He won the 2008 Nobel Memorial Prize in Economic Sciences for his work on international trade and economic geography.
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