The Most Important Number of the Week Is 3.1%

​​​Inflation? Meh. The Federal Reserve has it under control. That was the message sent by bond traders after the U.S. Commerce Department said Friday that a key measure of consumer prices is running at its highest level since 1992. They’re probably right. 

The debate over whether the recent acceleration in inflation is just transitory — as the Fed believes — or becoming entrenched is the most heated in the field of economics at the moment. The truth is, nobody can say for sure because there’s really no historical precedent for how the economy will react to trillions of dollars of fiscal and monetary stimulus during a global pandemic.

But it’s hard to discount the collective wisdom of bond traders and their uncanny ability to accurately predict where the economy is headed. Is it mere coincidence that the so-called yield curve, or difference between two- and 10-year Treasury note rates, inverted prior to each of the past eight recessions?

This is why Friday’s move in the bond market shouldn’t be ignored. Yields on benchmark 10-year U.S. Treasury notes, which move inversely to the price of the securities, dropped to as low as 1.58%, falling further from their highs of the year of 1.77% at the end of March even though the core personal consumption expenditure index rose 3.1% in April from a year earlier.

The Most Important Number of the Week Is 3.1%
The Most Important Number of the Week Is 3.1%

An astute reader would notice that yields are well below inflation, raising questions about the sanity of bond traders. In fact, “real” yields — which strip out inflation — haven’t been this negative since the mid-1970s. But markets are forward-looking and traders clearly don’t see a an increase in inflation rates over the long term. Otherwise, why would they continue to hold securities knowing full well that their fixed-interest payments would be perpetually eroded over time?

The Most Important Number of the Week Is 3.1%

And what about that 3.1% inflation rate, which is above the Fed’s 2% target? Isn’t that proof that the Fed is “falling behind the curve?” Actually, no. It’s what the Fed wants to see. The central bank has made clear that it’s willing to let inflation run hot before tightening monetary policy to make up for persistent shortfalls over the last decade. Given how well the Fed has managed to control inflation and steer it lower since the days of Paul Volcker in the early 1980s, bond traders see no reason to start doubting the central bank’s ability to rein in inflation when the time comes. 

It’s not hard to see why there are plenty of doubters. For starters, the supply of money has exploded. A Fed measure called M2 — which is cash, checking deposits, savings deposits, money-market funds and other items defined as “near money” — stood at $20.1 trillion as of the end of April, up from $15.3 trillion at the end of 2019. To put that $4.8 trillion increase in context, consider that the most M2 ever increased in a whole year was $952 billion in 2019. 

The Most Important Number of the Week Is 3.1%

All that cash, the inflationistas predict, is poised to pour into the economy at once as the pandemic eases further and people start to travel, shop and eat out more. The laws of supply and demand will then take over, forcing prices of goods and services higher. The dislocations we’re seeing now are largely a result of  supply-chain disruptions and bottlenecks that will eventually self-correct. 

For the moment, consumers seem content to hoard their money. The Commerce Department also said Friday that the personal saving rate remained at a lofty level in April, clocking in at 14.9%. The rate has averaged 18.4% since the pandemic started in March 2020, more than double the 7.6% in the prior decade. 

The Most Important Number of the Week Is 3.1%

It’s also hard to have sustained inflation when the frequency with which money changes hands, as people use it to buy goods and services, is so low. The “velocity” of money, already at all-time lows heading into the pandemic, has collapsed even further.

The Most Important Number of the Week Is 3.1%
Nobody seriously doubts that inflation won’t remain elevated for a while, probably through year-end at the least. But that’s largely because prices were so depressed in 2020.  It’s not that bond traders and the Fed are complacent; they just know that the trends that have kept inflation under control for much of the past three decades, such as continual advances in technology, information and delivery systems, are not going away. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Robert Burgess is the Executive Editor for Bloomberg Opinion. He is the former global Executive Editor in charge of financial markets for Bloomberg News. As managing editor, he led the company’s news coverage of credit markets during the global financial crisis.

©2021 Bloomberg L.P.

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