Is U.S. inflation here to stay? Here’s what the marketplace sees for the next 10 years
Inflation is real. We are all facing higher prices for stuff we regularly buy.
However, there is a big, and not just academic, debate over just how high prices will rise. The question is whether the inflation we are currently experiencing will be temporary.
Activity in the financial markets can help us answer these questions. The bond market reflects investors’ outlook for inflation.
History and economic theory teaches that interest rates on bonds, certificates of deposits, or any other debt securities are made up of two parts. First, the interest rate compensates the lender for the possibility of inflation. If prices rise over the term of the contract, the lender loses purchasing power. Thus, the stated interest rate on the loan includes a return for the expected inflation over the period.
The second component of an interest rate is the real return. This is the rate of return the investor is expected to make after adjusting for inflation. The bond or CD may pay you some positive rate, but after adjusting for inflation what you actually earn is called the real rate of interest.
This month Zions Bank in Boise posted a 0.30% rate of interest on 5-year certificates of deposit. If one deposits $1,000 with the bank and agrees to leave it there for the next five years, he or she will earn, with compounding, about $15 in interest. But if inflation runs at 2% a year for the next five years, the $15 in interest won’t mean much. The real return on this investment will be less than zero.
Current inflation is eating into returns.
Since 1948 the average annual rate of change in the Consumer Price Index, the most widely used measure of inflation in the United States, has been around 3%. In the most recent report the annual rate of inflation was over 5%.
To measure expected inflation we can look at the market for U.S. Treasury securities. What is called the break-even inflation rate is found by taking the current rate of interest on 10-year Treasury notes and subtracting the current rate on 10-year Treasury inflation-indexed notes. This difference implies what market participants expect inflation to be in the next 10 years, on average.
The break-even inflation rate currently stands at 2.5%, up from 1.6% before the pandemic. So while this market activity does suggest that the current above-average CPI rate will be temporary, there is an expectation that inflation will persist.
Financial markets say inflation is real and here to stay.
Peter Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa, Idaho. prcrabb@nnu.edu
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