U.S. Fixed Income

Is inflation Frozen too? Should the Fed Let it Go?

If the economy has been expanding for a decade, why isn’t inflation higher?
February 2020

At the end of 2019, Frozen II was released to the delight of children who had been counting down the days since the release of the original film in 2013. Their yearning for a sequel may only be surpassed by central banks’ desire for a resurgence in inflation. If the economy has been expanding for a decade, why isn’t inflation higher?

The reason to ponder the dog that didn’t bark is that inflation has significant impacts to fixed income markets both through implications directly to rates as well as for monetary policy. In discussing the Fed’s three rate cuts in 2019 at his December 2019 press conference, Chairman Powell stated that “inflation pressures were unexpectedly muted, strengthening the case for a more supportive stance of policy.”

Today’s inflation levels are a far cry from the 1970s when President Gerald Ford declared inflation “public enemy number one” or even from the 2008 financial crisis when deflation was the fear du jour. Yet, inflation seemingly persistently and stubbornly below targeted levels has perplexed and challenged markets. What unexplored factors could be influencing this outcome? Does inflation remain Frozen too? Should the Fed Let it Go?

Is inflation Frozen too - Cartoon

Some things never change

The Fed’s dual mandate was established in 1977 and one of those two mandates was ‘price stability.’ It is important to recall the significance of inflation at that time. Official measures showed inflation above 12% in 1970s, but inflation was palpable without a government tracker. It even extended into popular culture, for example when ‘All in the Family’ aired a four-part episode titled, “The Bunkers and Inflation.”

Tapping into this zeitgeist, President Ford delivered a speech entitled, “Whip Inflation Now” in 1974 and WIN buttons became common (if derided) attire. In his memoir, Ford’s Chairman of the Council of Economic Advisors described WIN as “unbelievably stupid” though publicly supporting it at the time. That Chairman would later go on to be Chairman of the Federal Reserve. In this later role, Alan Greenspan described ‘price stability’ as “that state in which expected changes in the general price level do not effectively alter business and household decisions.”

In the 1970s, inflation very much impacted business and household decisions. Were Congress to implement a Fed mandate today in contrast to the environment of the 1970s, the discussion around ‘price stability’ would be very different.

Into the unknown

The Fed has referred to inflation as ‘below target,’ but this begs an interesting question: how do you measure inflation? The two most commonly utilized metrics are Consumer Price Index (CPI) and Personal Consumption Expenditure (PCE), though many others exist. Even within those, variants differentiate between headline and core (excludes food and energy) as well as more subtle distinctions (standard calculation versus trimmed mean, all urban consumers versus urban wage earners and clerical workers), etc. Inflation may be a critical measure, but it is not a uniform one.

Different component weights within CPI and PCE as well as different methods in calculation have naturally led to different results in measuring inflation over time. For example, Core CPI has been approximately 60 basis points higher on average over the past 50 years than Core PCE (+4.0% vs. +3.4%, respectively).

Component CPI weight (%) PCE weight (%) Difference (%)

Food and beverages
















Medical care








Education and communication




Other goods and services




Source: Bureau of Economic Analysis 2015

Differences in the measurement may have been larger in absolute terms in the past, but when all measures of inflation were elevated, a broad consensus existed to combat it. Today, as core CPI and core PCE straddle the 2% target, the implications between one metric and the other could have profound policy implications. Were the Fed to focus on Core CPI, would it have felt as comfortable cutting rates in 2019?

Inflation above or below target? Depends how you measure it

Is inflation Frozen too - Inflation above or below target Depends on how you measure it chart

Source: Bureau of Labor Statistics

Show yourself

Though widely assumed to be around 2% for a long time, the Fed named its own explicit inflation target in 2012. This target is symmetrical, which is to say inflation below this measure would also be combatted, not just a ‘price stability’ goal, but a positive inflation goal. This was de facto policy of central banks globally coming out of the crisis, but this dictum made the actions into policy going forward.

In 1996, the Fed internally agreed on a 2% inflation target, but made no official pronouncement. Robert Heller, a former member of the U.S. Federal Reserve Board of governors, quoted Alan Greenspan as saying, “I will tell you that if the 2% inflation figure gets out of this room, it is going to create more problems for us than I think any of you might anticipate.”

Lost in the woods

What might those problems be? To explore the efficacy of inflation targeting, we consider Goodhart’s law. To paraphrase, this law states that when a measure becomes a target, it loses its value as a measure. The apocryphal example of this law is the Soviet nail factory. The factory was assessed by the number of nails it produced and so opted to produce a vast quantity of tiny, but useless nails. Once this ruse was uncovered, the target was shifted to weight of nails produced and the factory began to produce a smaller number of extremely large, but still useless, nails. Measuring nail production in a normal sense got lost once the measure became the target.

While somewhat easy to see how a measure of nail production could be abused once turned into a target, could the same apply to macroeconomic variables as significant and with as many inputs as inflation? At first glance, it could appear that too many factors are in play for inflation to be susceptible to Goodhart’s law, however, we believe this distortion could be occurring. (Goodhart himself was an economist and a member of the Bank of England’s Monetary Policy Committee.)

One important example is that CPI is used heavily for contractual cost of living adjustments (COLA) in both the public and private sectors. These adjustments may be for current employee contracts as well as retiree benefits. Federal tax brackets, which impact workers’ taxes, and income thresholds for government safety net programs, which impact who is eligible to receive these payments, are all tied to inflation adjustments. This is not a mere academic exercise as these figures can be quite significant — for example, according to the Social Security Administration, approximately 64 million Americans received over $1 trillion in payments in 2019 — each payment being subject to the CPI COLA.

As workers and retirees receive pay and benefit increases tethered to inflation, it links their ability to spend future wages and benefits to how much inflation has been, but their spending impacts future inflation. This situation is already somewhat circular, but when the Fed imposes a target, it can impact consumer behavior, which in turn impacts CPI and thus their future cost of living adjustments.

Further, if employers know that inflation is targeted at 2% it reduces their incentive to offer wage increases. Of course, employers are not keen to pay employees more and competition for labor is the primary force driving wages higher. However, there is large degree of opacity in wages, so employers knowing the inflation target as opposed to guessing their competition’s actions may be a contributing factor to slower wage growth. (Let us know if you’d like a copy of this paper without this paragraph for your boss.)

This is our concern of inflation targeting, that by the Fed employing inflation as a target, it has distorted actual inflationary/disinflationary inputs, but then reads the observed inflation levels as guidance for policy.

Do you want to build a… market based measure of inflation?

One of the Treasury’s goals in introducing TIPS (Treasury Inflation Protected Securities) in 1997 was to create a market-based measure of inflation expectations. The difference between yields on typical Treasury bonds (nominals) and TIPS is the implied market inflation expectation. This gap is the amount of inflation needed for the TIPS holder to break-even with owning a nominal Treasury and hence this measure is also known as “break-evens.”

Market measures can be valuable as other systems of measurement, such as survey data, have other flaws. Recently, the NY Fed inflation survey showed consumer expectations of U.S. inflation had hit their lowest point ever at 2.4% for the next three years. This number is noteworthy as CPI only rose 2.3% in 2019, yet was the largest increase since 2011.

This brings us to the challenge of market-based expectations and the observer effect, raising the question of whether using a market-based output to measure inflation expectations itself distorts inflation expectations. The Fed watching TIPS for inflation signals likely distorts interpretation of TIPS break-evens as an accurate measure of inflation expectations because the markets knows that the Fed may adjust policy based on the break-evens it is monitoring.

Have TIPS predicted future inflation?

Is inflation Frozen too - Have TIPS predicted future inflation chart

Source: BMO Fixed Income, Bloomberg

All is found…or is it? What else could distort TIPS?

The observer effect is not the only factor potentially distorting TIPS as a measure of inflation. A Fed paper on TIPS acknowledges that, at least historically, there was an illiquidity premium for TIPS relative to nominal Treasuries; by (at least theoretically) making TIPS cheaper, this would reduce break-evens and understate inflation expectations. This creates its own challenge then as using TIPS as a true reflection of inflation expectations.

This illiquidity premium is in part due to the relative size of the markets — nominal Treasuries are eight times as large a market (notes and bonds are approximately $12 trillion) as inflation-adjusted securities ($1.5 trillion). We are left to assume this is the proper ratio — were issuance to shift and one to grow versus the other, this should impact raw supply/demand dynamics even if not truly saying anything about inflation.

Balance of nominal and inflation-adjusted treasury debt outstanding

Is inflation Frozen too - Balance of nominal and inflation-adjusted treasury debt outstanding chart

Source: BMO Fixed Income, SIFMA

Also noteworthy in the use of TIPS as an indicator is the fact that they track headline CPI not core CPI. Headline measures include both food and energy prices, which are excluded in the Core measure and are viewed to be more volatile and transient. Though these are often excluded from more academic measures of inflation, when we think of the original intent of inflation measuring, it is these measures that are most likely to cause discomfort to the populace. The recent yellow vest movement in France began as a protest against gas taxes, which would increase costs to French consumers, and the recent spike in Chinese pork prices or rice prices in Asia in 2008 were causes for alarm. This helps explain the disconnect between what most consumers intuitively feel is happening with prices and the Fed’s more statistical approach.

10-year break-evens versus oil prices

Oil prices, a key input to headline but not core inflations, have generally shown high correlation to market-based inflation expectations prices.

Is inflation Frozen too - 10-year break-evens versus oil prices chart

Source: BMO Fixed Income, Bloomberg

The past is not what it seems—is QE inflationary?

The demand side of the equation matters as well. It should be noted that the Fed takes pains to minimize market impact when buying securities by appending their orders to already market clearing levels. Nonetheless, by absorbing some of the Treasury’s funding needs, the Fed alters the supply/demand balance as those funding needs would have to be sourced elsewhere absent the Fed’s actions.

One of the expressed concerns regarding quantitative easing was that it would be overly inflationary. The Fed accumulated approximately 14% of the outstanding nominal Treasuries during QE, injecting liquidity into the system, removing Treasuries from circulation and lowering rates.

At the same time, the Fed owns about 10% of outstanding TIPS issuance. By buying a larger proportion of nominals than TIPS, did the Fed effectively sell break-evens? In this case, did the Fed’s actions actually lower rather than raise inflation expectations on the margin?

Chairman Powell has stated that “once inflation expectations start sliding down, inflation moves down.” If this view is right and the Fed lowered inflation expectations by effectively selling break-evens, was QE effectively disinflationary rather than inflationary?

This also raises the question of whether the Fed could institute TIPS versus nominals trades as a proactive policy tool — similar to how Operation Twist in 2011 focused on maturities of Fed bond holdings versus growing the balance sheet. If the Fed believes that inflation expectations drive inflation, this could be a more effective and direct tool than changes to the Fed Funds Rate.

Conclusions: doing the next right thing

The history of inflation helps explain its significance today. Inflation has gone from a destroyer of wealth to a measure of economic health. It has taken on the complicated function as an economic indicator as well as a policy target — making its role significant, but conflicted.

When a central bank announces a (realistic) target, it becomes a measure of credibility of that institution. To date, the Fed’s credibility remains strong, making an inflation breakout unlikely. The Fed is expected to announce adjustments to their inflation framework midyear, but we do not expect changes significant enough to allow inflation to rise to the levels of prior eras. Further, because inflation has become increasingly circular as inflation drives COLAs, which then impacts spending, meaningful inflation absent significant structural shifts is difficult to foresee.

Given these factors, our view is that inflation will remain structurally low and sticky. We believe the implications for markets and policy are lower long-run rates and an accommodative Fed. While we believe low inflation creates a ceiling on rates well below historical levels, we are cautious not to suggest rates must remain at today’s levels. Interest rates will continue to fluctuate based on a variety of inputs, including short-term inflation data, and may again move higher. But in the absence of a paradigm shift, they are unlikely to break free from recent ranges.

The evolution of inflation and expectations for its impacts on policy and markets should give investors and market participants comfort in fixed income as an asset class. It may take magic to unfreeze inflation, but that should be just fine for bonds.

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This report contains our opinion as of the date the report was generated. It is for general information purposes only and is not intended to predict or guarantee the future performance of any investment, investment manager, market sector, or the markets generally. We will not update this report or advise you if there is any change in this report or our opinion. The information, ratings, and opinions in this report are based on numerous sources believed to be reliable, such as investment managers, custodians, mutual fund companies, and third-party data and service providers. We do not represent or warrant that the report is accurate or complete.

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