8 early warning signs inflation is percolating

When it comes to inflation there are some early warning signs that investors can monitor. Inflation may be low at the moment, but some type of shock or monetary policy mistake could potentially spur "significant and sustained increases in inflation."

By Robert Powell
Sept. 26, 2012, 12:01 a.m. EDT
Market Watch

BOSTON (MarketWatch) — They don’t ring a bell at the top of a bull market nor at the bottom of a bear market. But when it comes to inflation there are some early warning signs that investors can monitor, according to a new report.

Inflation is relatively low at the moment. But two risks — some type of shock or monetary policy mistake — could potentially spur “significant and sustained increases in inflation,” according to Michael Hood, a strategist at J.P. Morgan Asset Management and author of “Managing Inflation.”

And, thankfully, Hood said in an interview and in his report that there are “eight early warning signs to monitor that will detect growing imbalances that could ultimately lead to upward pressure on prices.”

As a group, Hood said the indicators — ranging from surveys that track inflation expectations and labor-market dynamics to indexes that track and capture global trends in available resources — are flashing green, suggesting there is little cause for concern.

Still, there’s nothing quite like a little heads up, especially given how easy it is to monitor the indicators that Hood says are worth watching.

In his report, Hood gave color-coded ranges for investors to track each of the indicators, with numbers in the green range being safe, numbers in the yellow range being worrisome and numbers in the red range being, well, trouble.

“We tried to give investors ranges that will tip them off to when things might become problematic,” he said. “The idea was to give people information that they could work with themselves.”

When watching for inflation, Hood said investors shouldn’t focus on any one indicator. But should four of the eight indicators enter the yellow or red zones that would be cause for concern.

“We always caution people not to try to find the one magical indicator you can rely on to the exclusion of all others because any one series, however reliable and quality it is, can get pushed around by specific factors,” said Hood. “And so what you are looking for is the weight of evidence. So, if you start to see a number of things, and four is as good a number as any, start to move that’s probably time to question your pre-existing view.”

So, without further delay, here’s a look at the eight indicators Hood recommends watching:

1. 5y5y forward inflation breakeven

According to Hood, the Fed’s preferred market-based measure of inflation expectations is the “breakeven” rate, or the distance between real interest rates in the TIPS market and nominal interest rates on regular U.S. Treasurys. The Fed watches this rate, according to the report, as a gauge of medium-term expectations.

The breakeven rate has averaged 2.7% since 2000, which is slightly higher than the Fed’s 2% inflation target, according to Hood.

Anything below 3% is — in the main — good. But a sustained move significantly above 2.7% — say, to 3% or higher — would signal a possible anchoring of inflation expectations in the market, with a rise above 3.3% putting this indicator in the red, Hood wrote.

The breakeven rate has ticked up from 2.5% when Hood first published his report in August to 2.7% in the wake of the Federal Reserve announcing QE3 two weeks ago. But that’s not a cause for concern yet. “The breakevens are not high by any long-term standards, and they don’t show any signs of becoming unanchored,” Hood said.

2. Long-term inflation expectations from the University of Michigan consumer survey

The monthly consumer confidence survey conducted by the University of Michigan includes short- and long-term inflation expectations, according to Hood. And that means it captures forecasts made by average Americans.

Since 2000, the number has averaged 2.9%, but a move to the 3.2% area that lasts for six months or more would suggest “that expectations are coming unglued, with readings of 3.6% or higher generating even more concern,” according to Hood.

3. Employment cost index

In order for a true inflationary process to become entrenched in the economy, wage growth needs to participate, said Hood. Thus, tracking wage increase is an essential component of inflation-watching.

And the index to watch is the Employment Cost Index (ECI). Though published only quarterly it is broad in its coverage and includes benefit costs along with wages.

The ECI, which stands roughly at 2%, would need to “accelerate to a 3.5%-4.25% pace before triggering significant concern,” Hood wrote.

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