In my previous article, I explained why you should take a step back when you are bombarded by doomsayers’ claims that high inflation will cause the “biggest recession in history”. Most people do not understand that inflation is not the root cause of the recession. Rather, inflation is a man-made tool to be used as an “excuse” to raise the interest rate so it can be cut again in the future. It is a tool for wealth redistribution.
So why does the market worry about inflation? Actually, the market is not worried about the particular inflation numbers. Rather, the market is worried about possible policy missteps to manage inflation. For example, the policymakers may let it run too fast or too slow. If some unforeseen black swan events, such as a global pandemic, happen, there could be undesired consequences.
The Russia-Ukraine war was a perfect opportunity for the US to achieve their average inflation target. But I think during the process, both Russia and the US made some miscalculations. So now they have to amend it.
Who says inflation cannot be controlled?
Just take a look at the recent mysterious freefall of energy prices and agriculture commodity prices. How do you explain that?
Most importantly, while everybody is still talking about inflation, the financial market already knew the peak of inflation may be over. Here is why…
Inflation and inflation expectations are not the same
Just because inflation was 8.6% last month, it doesn’t mean it will be the same or higher for the rest of the year.
You need to understand actual inflation and inflation expectations are not the same things.
The numbers you saw in the news headline are Actual Inflation. But what you should really pay attention to is the Inflation Expectation.
Actual inflations are typically measured by the Consumer Price Index, a.k.a the CPI. The CPI measures the monthly change in prices paid by consumers. The government calculates the CPI as average prices for a basket of goods and services. So it is survey data.
Humans are terrible at statistics. They like to extrapolate the numbers.
If you see 2, 4, 6…
What do you expect to be the next number?
But why not 10? (When the number is the sum of the previous 2 numbers)
It is the exact same reason why people lose money in the stock market. When they see a stock or crypto going up 10% this month, they think it will go up another 10% next month. The same applies when they go down. If you lose 10% this month, it doesn’t mean you will lose another 10% next month.
Wealth never grows in the linear term. – Ivan Guan
This is one of the 3 important mindsets you must have if you want to be rich.
Additional Reading: 3 rich mindsets you must have to achieve financial freedom
Let’s come back to inflation.
The CPI is a measure of inflation but it only measures the past. The financial market always looks to the future.
Just because you pump oil at $3 per litre today, doesn’t mean that you should expect it to be the same next year.
The inflation expectations are what the financial market thinks about inflation. The number is derived by trading inflation-linked investments. I won’t touch on the methodology today as it needs a bit of explanation. You only need to understand one thing:
Actual inflation is what people say; but, inflation expectations are where professional investors make a bet with real money.
Which one do you think is more trustworthy?
Inflation expectations are coming down
If you look at the CPI chart, US inflation is 8.6% now. It’s scary!
But if you look at the inflation expectation today, the 2-year inflation expectation already peaked in March and then it crashed to 3.17%!
So what does it mean?
Well, think about it. People were blaming inflation for everything. Food becomes more expensive, bread becomes smaller, and electrical bills become higher.
In the financial market, inflation was blamed for interest rate hikes, stock market crashes, high commodity prices and recession. But what if these assumptions may no longer be valid?
Let’s not forget that the US set a long-term inflation target of 2% in 2020. And it is a framework that they will follow.
The inflation already reached 4% in April 2021 and 6% in Oct 2021 and it is more than 8% since March 2022. Will the next number be 10%? I think it is unlikely.
Remember I said earlier that the world doesn’t have to operate in a non-linear process?
In my opinion, I think there is a high chance that last month’s inflation is a peak in the near term.
What happens when the inflation rate starts coming down?
There is a saying in the commodity world, “The only way to kill high oil prices is the high oil price itself”. Nothing moves in one direction. When the price movement is too extreme, it is like a rubber band, the elasticity will pull it back.
If inflation fear is the trigger of the recent stock market crash, will a lower inflation expectation bring the market back up?
When the Fed raised the interest rate by 0.75% last month, the stock market cheered instead of going down. Why? Think about it.
That’s why we need to talk about the other side of the inflation equation, the Interest Rate!
Will inflation expectation trigger a reversal of interest rate expectations? If so, how will it affect the stocks, bonds and commodity prices?
I will discuss this in my next blog post, remember to subscribe to my mailing list below to be notified.
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