Inflation measures how much more expensive a set of goods and services has become over a certain period, usually a year. A white paper from Fathom Consulting and Refinitiv explores the shortcomings of traditional measures of inflation expectations.
- Traditional measures of inflation expectations – survey and market-based measures – produce limited results that are not of great value to quant analysts.
- Composite and portfolio-based measures track expected inflation and produce results that can be used to increase asset and portfolio performance.
- Risks to the inflation outlook can yield further returns for inflation-sensitive assets.
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This blog derives from a white paper written by our partners, Fathom Consulting.
The white paper, A framework for thinking about inflation expectations and surprises, outlines some practical approaches quantitative analysts can take to forecast near-term inflation developments and include these in portfolio construction.
It also considers risks to an inflation outlook that could prove profitable for portfolios exposed to inflation surprises.
How to track inflation
There are a number of methodologies that are used routinely by investors to gauge the evolution of expected inflation. None of them are perfect and each has its own strengths and weaknesses.
The paper notes the limitations of survey-based measures and market-based measures, and focuses on the use of composite measures, including principal component analysis, and portfolio-based measures based on the construction of factor mimicking portfolios.
Risks to the inflation outlook
The white paper notes three risks to the inflation outlook and their potential for investors:
- Persistence of labour market friction – a permanent increase in labour market friction represents a negative supply shock. It would be a positive outcome for portfolios geared towards inflation surprises and negative for those geared towards growth in output.
- Excess savings are spent – average U.S. disposable incomes rose last year as a result of fiscal support measures, but very little of this extra income was spent. If the savings were spent, this would represent an upside risk to inflation and be positive for those holding the macro cycle factor-mimicking portfolio (FMP), but not necessarily for those holding the inflation surprise FMP.
- Expectations slip their anchor – household inflation expectations appear to be rising. If higher expectations persist, the U.S. risks persistently higher inflation. If this occurs, it would be positive for assets related to inflation surprises in the short term.
How can accurate inflation expectations enhance investments?
The white paper outlines methodologies to track short-term movements in inflation that can be used to increase asset and portfolio performance.
It also demonstrates that risks to the inflation outlook can yield further returns for inflation-sensitive assets.