After being given up for dead, inflation is gradually coming back to life.
It’s not roaring back. Indeed, it’s still below the 2% level the Federal Reserve targets, one reason the Fed is almost certain to leave interest rates unchanged when it meets this week.
But economic circumstances and attitudes of policy makers have shifted in the past year in ways that suggest the likeliest path of inflation is up, not down. Data released Friday showed that core inflation, which excludes food and energy, reached a two-year high of 1.7% in the third quarter, according to the Fed’s preferred measure. Other data found stirrings of wage acceleration.
The intellectual case for low inflation is also showing cracks. Central banks now openly entertain, and even welcome, inflation bubbling over 2%.
This isn’t bad news. To the contrary, markets and central bankers alike will be relieved that the world is no longer skirting a deflationary abyss. Normal inflation is a necessary (though not sufficient) condition for savers to once again enjoy normal interest rates.
Nonetheless, it could portend a significant repricing in financial markets, which had come to assume inflation would be too low forever. Since early July the U.S. 10-year Treasury yield (which moves in the opposite direction to price) has climbed half a percentage point to 1.85%. Yields in other countries have risen somewhat less.
Most of this increase reflects a reappraisal of the inflation outlook. The behavior of inflation-protected bonds suggests that in early July, investors expected U.S. inflation to average 1.4% over the coming decade. As of Friday, that had risen to 1.7%.
That is still below the Fed’s 2% target, evidence that investors remain unconvinced the Fed has licked the low-inflation problem. Yet many of the assumptions that underpin their skepticism are no longer warranted: that excess capacity and low oil prices will last indefinitely, that elected governments are fixated on austerity, and that central banks will clamp down if they see inflation about to top 2%.
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