Are Inflationary Expectations Overblown?

On Friday, July 12, 2013 consumer sentiment as measured by the University of Michigan fell for the first time in 2013. A reading of 83.9 in July came in below estimates of 84.7 and has brought about some fears that rising interest rates and gas prices may be affecting consumer expectations.

But, should we even care about these surveys or the consumer's feelings? Notwithstanding the controversy surrounding the "pay to play" early release rights of certain companies to this data, given what seems to be the absurdity in some of the responses by consumers I am inclined to ignore all these types of surveys.

The Absurdity of Survey Responses

In the latest sentiment survey release it was reported that consumers "expect an inflation rate of 3.3% over the next 12 months, up from the June forecast of 3 percent. Over the next five years consumers expect a 2.9% rate of inflation, matching the previous three months".

The chart below of the Consumer Price Index with the dashed horizontal line at 3% sums up why the consumer's answer is borderline absurd.

The Consumer Price Index (NYSEARCA:TIP), which is the proxy index for tracking consumer inflation, has not been above 3.3% since 2011, and even then it was short lived. The chart below shows the annual change in the CPI (NYSEARCA:WIP) over the last 20 years along with a five year moving average of that change.

Current CPI as shown in the chart is at 1.4% and the five year average is now below 2%, well below the Sentiment survey's 3.3% expectation and five year expectation of 2.9%. In fact, only once since 1996 has the five year average CPI even been above 3% (briefly in 2008)!

Creatures of HabitBut this is nothing new. Consumers have expected inflation to be around3% for, well, pretty much forever, regardless of reality. Last July's survey also resultedin (no surprise) an inflation expectation of 3%. In July 2011 the expectation was for a similar 3.4%inflation. The table below shows the 15year history of expected vs. actual year over year inflation. The average 15 year inflation expectation hasbeen 3% with a median expectation also of 3%.But here is the problem, in these15 years the consumer has overestimated inflation every year by around 25% and inthe last 5 years by over 50%. Theconsumer has only been remotely close to reality four out of 15 times.

At this point it seems the forever "3% inflation" threshold has been burned into the consumer's mind, but it certainly is not correct.

In reality inflation is nowhere near the currently expected 3.3%, has not generally been since pre-1996, and continues to come in around 50% lower than expectations. There is really no real reason for the consumer to continue to expect 3% inflation.

Given the consumer's propensity to anchor to such wrong expectations, should we even concern ourselves with their other thoughts and expectations in these kinds of surveys?

A Better Choice

Following the actual markets for a better inflation gauge makes much more sense as inflation is an inherent part of the dollar, commodity, and bond prices (NYSEARCA:TLT). This is why in our May ETF Profit Strategy Newsletter published 4/19 when gold (NYSEARCA:GLD) was still above $1400 we focused on the decline in the precious metals (NYSEARCA:IAU) and warned, "Commodities (NYSEARCA:DBC) as a whole continue to decline from their 2008 price peaks which is more consistent with the continued risk of deflation, not inflation. This may help explain why the Fed continues to pump money into the economy, even in the face of a supposedly "rebounding" one."

The final chart provided to subscribers and shown below of the CRB Index displays the rising deflationary threat through a basket of commodities (NYSEARCA:DJP). This index is more in line with the Producer Price Index (PPI) as a proxy of cost inflation for companies. These cost pressures should eventually trickle down to consumers through lower costs as companies compete for revenues.

Commodities rise in price during times of inflationary expectations and decline during deflationary times as the U.S. dollar goes further in its purchasing power (for more on the dollar's role in inflation see "Inflation vs Deflation. Who is Winning"). The chart below shows which situation is more likely upon us as commodities continue to fall in price.

Actions speak louder than words, and the Fed's actions also suggest inflation is far from a threat right now. Chairman Bernanke reiterated this on 7/10 in his now infamous Q&A session, "I think you can only conclude that highly accommodative monetary policy for the foreseeable future is what's needed in the U.S. economy". Commodities (NYSEARCA:GCC) and the dollar agree in the negative growth outlook as the chart above implies.

With the recent rally in the dollar (NYSEARCA:UUP) and sell off in foreign currencies (NYSEARCA:FXE), this risk continues to get even greater.

Perhaps it is time for the consumer and the media to also finally wake up to the new reality of the situation - that inflation of 3% is and has been long gone.

The ETF Profit Strategy Newsletter uses common sense, sentiment, and technical analysis to stay ahead of the inflation argument and other prevailing market trends. We also publish a twice weekly Technical Forecast and Weekly ETF Pick which focus on the shorter-term trends in the stock, bond, currency, and commodity markets.