Early Inflation Warning Signs for Investors

September 14, 2012 (PLANSPONSOR.com) Inflation has remained steady in the U.S. and most developed countries in the aftermath of the economic crisis.

With the exception of Japan, deflation has failed to take hold despite low levels of economic activity and high unemployment rates. But two risks some type of shock or monetary policy mistake have the potential to incite significant and sustained increases in inflation.

According to J.P. Morgan Asset Management, there are eight early warning signs to monitor in order to detect increasing imbalances that could ultimately lead to upward pressure on prices. These indicators range from surveys that track inflation expectations and labor market dynamics, to indexes that track and capture global trends in available resources.

“I wouldn’t think about each of these indicators in isolation,” Michael Hood, strategist at J.P. Morgan Asset Management, told PLANSPONSOR. He emphasized that there is little cause for concern at this point unless several of these warning signs are triggered simultaneously.

Hood said he does not see an inflation problem on the horizon, but that warning signs from J.P. Morgan’s report, “Managing Inflation: Its drivers and eight early warning signs,” can help investors prepare. Here are a few to watch for:

The 5y5y Forward Inflation Breakeven  

The Federal Reserve watches the 5y5y forward “breakeven” rate as a gauge of medium-term expectations. The breakeven is the difference between the nominal U.S. Treasury rate and the yield on Treasury Inflation-Protected Securities (TIPS).

Since 2000, the breakeven rate has averaged 2.7%, somewhat higher than the 2% inflation target. The current 5y5y forward breakeven is roughly 2.4%, below its medium-term average. A sustained move significantly above 2.7% (3% or higher) would signal a possible deanchoring of inflation expectations in the market, with a rise beyond 3.3% putting this indicator in “red” territory, the report said.

Long-Term Inflation Expectations From Surveys 

A consumer survey by the University of Michigan asked respondents about short- and long-term inflation expectations, capturing forecasts from ordinary households. The 5- to 10-year ahead expectations approached double digits when the survey began around 1980, gradually declining to the 3% range over the next 15 years.

Since 2000, it has been stable at an average of 2.9%. A move to the 3.2% area lasting for six months or longer would suggest concern, the report said.

The Fed’s Unemployment Forecast 

The report suggested that investors monitor the relationship between the actual unemployment rate, the Fed’s neutral-rate estimate and other indicators of labor market slack including measures of wage inflation for signs that pressure is building.

Hood said that the Fed’s unemployment rate outlook over the long-term is much lower than today's rate. “So that’s a sign that the Fed is comfortable,” he continued, adding that this indicates there is slack in the economy.

Conversely, if the Fed bumps up its unemployment estimate, that is a sign that there is less slack in the economy, increasing the medium-term inflation risk.

In general, Hood suggested that an effective inflation-protection strategy is increasing allocations to “real” assets (e.g. equities). Equities are able to serve at least as a partial inflation hedge over the medium-term. Equities, however, are lower at periods of high inflation. “You should do fine over the long-term [with equities], but you can suffer during the inflation spike,” he said.

The paper is available here.