How high can inflation go?

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?

8?

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.

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?

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