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The New Inflation Picture

Following Russia's invasion of Ukraine, the bond market's 5-10 year projection of annual chain-weighted personal-consumption-expenditures inflation reached 2.27%, raising concerns that another big shock could de-anchor inflation expectations. But since that didn't happen, the Federal Reserve now should reconsider its position.

BERKELEY – At the start of February 2022, the five-year, five-year-forward consumer-price-index (CPI) inflation break-even rate in the US bond market was hovering at around 2% per year – a figure that corresponds to a chain-weighted personal-consumption-expenditures (PCE) inflation forecast of 1.6% per year 5-10 years from now. Since 1.6% inflation is materially below the US Federal Reserve’s 2% target, I entered that month feeling quite good about being on “Team Transitory” – or at least on “Team The Fed Has Got This” or “Team Inflation Expectations Remain Solidly Anchored.”

But then, at the end of that month, Russian President Vladimir Putin – the wannabe Grand Prince of Muscovy – ordered a blitzkrieg invasion of Ukraine. Things did not go as he had planned. The Ukrainians fended off the initial onslaught, and both sides settled in for a longer war of attrition. Energy, grain, and fertilizer prices skyrocketed. The world began to worry that, come winter, Europe would freeze and many other countries – from Egypt to Nigeria – would starve.

Owing to these fears, the five-year, five-year-forward CPI inflation rate shot up from 2% per year to its peak of 2.67% on April 21, 2022, while expectations of annual PCE inflation 5-10 years hence reached 2.27%. That PCE projection suggested that bond traders had not lost confidence in the Fed’s commitment to its inflation target.