July 3, 2021
Inflation has become one of those inescapable topics.
In certain circles, everyone seems compelled to talk or write about surging prices, and some economists and bond mavens even sound as though they know where inflation is heading.
But there are good reasons to question that aura of certainty.
In fact, thanks to some new research, one thing is clear: Bond traders and academic and corporate economists don’t have any real ability to predict whether inflation will rise or fall in the months and years ahead. Neither do consumers.
As far as major shifts in inflation go, we are all in the dark — just as we are essentially clueless about where the stock market is heading or the price of oil in 2022, or the date of the next recession.
Two staff members at a nonpartisan Washington think tank — the Peterson Institute for International Economics — conducted the inflation research. They are Joseph E. Gagnon, a senior fellow at the institute who was an official at the Federal Reserve and an economist at the U.S. Treasury, and Madi Sarsenbayev, an institute fellow.
In a pithy message on Twitter, Gagnon summarized their scholarly findings, which the institute published in four separate posts. “Bottom line: nobody forecasts well,” he said.
Gagnon discussed his research with me in a video chat. I suggested that his work provided fresh evidence that reliable and consistent forecasts about the economy and the markets were vanishingly rare. “I think that’s exactly right,” Gagnon said. “Nobody can predict big changes in inflation.”
That said, some groups of forecasters are less terrible than others. Economists are just “slightly better” than the typical supermarket shopper who notices that the price of milk has risen lately.
Then there is the bond market, which is often said to embody the “wisdom of crowds.” Under the “efficient markets” hypothesis, asset prices are thought to contain all aggregate knowledge. Inflation is so important in bond pricing that bonds may conceivably be capable of telling us where inflation is heading.
But, no: The study shows that the bond market is no good at this, either. Again, the research draws finer distinctions. Bond mavens are a little better than economists at predicting short-term inflation, while economists are a smidgen better than bond mavens at looking a few years ahead.
“However,” Gagnon and Sarsenbayev wrote, “neither bond markets nor economists have a great track record at forecasting inflation.” So it would be unwise to take comfort from current prices, which suggest that inflation will be no more than 2% next year. To the contrary, the two economists wrote, based on the bond market’s well-documented myopia, “more persistent inflation cannot be ruled out.”
The study’s various statistical comparisons relied on data from the University of Michigan Surveys of Consumers, the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters and the Bureau of Labor Statistics’ Consumer Price Index going back to the 1970s. It delved deep into the weeds, and for those with a passing knowledge of statistics, it’s well worth reading.
For everybody else, I’d suggest that their findings have some important implications.
If you happen to be lucky enough to have some money to invest, relax. You don’t need a crystal ball. Embrace a buy-and-hold strategy, setting up a portfolio with diverse, low-cost index funds, including stocks and bonds, in an appropriate asset allocation.
The much derided, old-fashioned 60-40 allocation — 60% stocks and 40% bonds — remains a reasonable place to start. Add stocks to the mix if you want to take on more risk. Add bonds, preferably Treasurys, if you want more safety. It’s true that if inflation surges, bond prices could be expected to fall, but not by much: The stock market can lose more in a week than the bond market loses in a bad year.
This is evident if you look at historical stock and bond returns. Vanguard has charts that show the performance from 1926 to 2020 of indexed portfolios with different asset allocations — from those with 100% stocks to those that have only bonds. Here are a few highlights:
- A 100% stock portfolio had a 10.3% average annual return. It produced losses in 25 of those 95 years, and the worst year was 1931, with a 43.1% loss
- The old standby, a 60-40 portfolio, had a 9.1% average annual return. Twenty-two years produced losses, and the worst year, also 1931, had a 26.6% loss. Note that bonds staved off the deeper losses of the pure stock investment.
- A 100% bond portfolio had a 6.1% average annual return. Nineteen years produced losses, and the worst year was 1969, with an 8.1% loss. Inflation in 1969 soared to 5%, yet the loss for bonds was inconsequential compared with those in bad years for stocks.
If, at the moment, inflation is your big worry and you are a homeowner, there is some solace. Real estate often does spectacularly well in inflationary periods.
But the Fed has kept inflation quite low for decades, and has the tools to reduce it should prices spike, Gagnon said. The central bank is deliberately trying to move the inflation rate just a bit higher — raising its target to 2.5% from 2% annually — for two main reasons.
One is that a higher inflation rate, which would lead to somewhat higher interest rates, could give the central bank more leeway to respond to the next recession, without being as constrained by “the zero lower bound” — the fact that short-term rates have hovered close to zero in the last two recessions.
The other is that by refraining from raising interest rates prematurely and by allowing inflation to rise modestly, the Fed may be able to keep unemployment falling. Greater demand for labor can give working people a shot at substantial wage increases. For decades, stock market returns have outpaced nearly everyone’s raises. Poorer people and many people of color in the United States and around the world have been left behind.
Despite the negative headlines about inflation, more of it may even turn out to be a good thing.
In any case, there’s little point in worrying, because we don’t know where we’re heading. Uncertainty is part of life. We all deal with it every day. It’s when people act as if they can predict the future that they scare me.
This article originally appeared in The New York Times.
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