By Christopher Diodato – TradersBase.com
The Fed places great important on both inflation and inflation expectations, but how do they forecast the future with them? Well, perhaps they should hire a technical analyst, because we can create a forecast for future inflation with reasonable confidence that it will be correct.
Here is a chart with 5 year inflation expectations (blue) and actual annual inflation as measured by the CPI (green).
Things to note
- Inflation expectations lead actual inflation by about three months
- Expected inflation is usually correct as to the future path of inflation, but severely underestimates it. This is likely due to the difference in durations.
The next step is to create a momentum indicator from these two values. I chose an 8 week momentum, which is a fraction of the four year business cycle and twice as long as the current S & P 500 cycle.
The light blue line is the 8 week momentum of the real inflation rate while the purple line is the 8 week momentum of the expected inflation rate. Now, we can go one step further than the previous chart and say that expected inflation momentum tends to bounce around the -.02 line on this chart. That being said, expectations recently bounced from that low, and are crossing the zero line. This means that markets and the economy are primed for more future inflation. However, markets are likely not ready for the consequences of such inflation. Let’s hope Mr. Bernanke knows what he will be getting into if he begins QE3 this week.