Expected Inflation

Expected inflation is the rate at which consumers, businesses, and investors anticipate the general level of prices for goods and services to rise over a future period. It’s not about what inflation was yesterday, but what the collective “wisdom of the crowd” thinks it will be tomorrow, next year, or even over the next decade. This shared belief is incredibly powerful because it shapes economic decisions today. If people expect prices to rise quickly, they might demand higher wages, rush to buy goods now before they become more expensive, and demand higher interest rates on the money they lend. For an investor, understanding expected inflation is not just an academic exercise; it is fundamental to calculating the true return on an investment and assessing the long-term value of a business. It’s the invisible force that can either supercharge your returns or silently eat them away.

At its core, value investing is about buying assets for less than their intrinsic worth and protecting your capital. Expected inflation is a direct threat to both of these goals.

Imagine you earn a 7% return on a stock in a year. Not bad, right? But if expected inflation for that year was 5%, your real return—your actual increase in purchasing power—is only about 2%. This is the crucial distinction between a nominal return (the 7% number you see on your statement) and a real return (what you can actually buy with your profits). The relationship is often summarized by the Fisher Equation, which states that the nominal interest rate is approximately the sum of the real interest rate and the expected inflation rate. As an investor, your goal is always to achieve a positive real return. High expected inflation sets a higher bar that your investments must clear just to maintain your current wealth.

Expected inflation directly impacts the valuation of a company. When you analyze a business, you are forecasting its future cash flow. High expected inflation can be a double-edged sword:

• Costs and Revenues: A company might face rising costs for labor and materials. The key question for a value investor is whether the company has pricing power—the ability to pass these higher costs on to its customers without losing business. Companies with strong brands and unique products often do, while companies selling commodities often don't.
• Discount Rates: To calculate a company's worth today, you must discount its future cash flows back to the present. This is the essence of a Discounted Cash Flow (DCF) analysis. The discount rate you use must account for expected inflation. Higher expected inflation leads to a higher discount rate, which in turn lowers the calculated present value of the business. In other words, the same future earnings are worth less today when inflation is expected to be high.

While no one has a crystal ball, economists and investors use a few key methods to get a reading on the future.

One straightforward way to gauge expectations is to ask people. Various organizations conduct regular surveys of consumers, professional economists, and business leaders. Famous examples include the University of Michigan's Survey of Consumers and the Survey of Professional Forecasters conducted by the Federal Reserve Bank of Philadelphia. These surveys provide a direct glimpse into what different groups are thinking. However, they can be influenced by recent headlines and sentiment, and people aren't always great at predicting the future.

A more data-driven approach is to look at what financial markets are signaling. This method assumes that the collective actions of millions of investors embed a sophisticated forecast into asset prices.

The most popular market-based measure is the breakeven inflation rate, often called the “TIPS spread” in the United States. The concept is simple and elegant. Governments issue two main types of bonds:

• Conventional Bonds: Such as a standard U.S. Treasury Note, which pays a fixed interest rate.
• Inflation-Protected Bonds: Such as Treasury Inflation-Protected Securities (TIPS) in the US. These bonds pay a lower interest rate, but their principal value adjusts upwards with inflation.

The breakeven inflation rate is the difference in the yield between these two types of bonds for the same maturity. For example, if a 10-year Treasury note yields 4.0% and a 10-year TIPS yields 1.5%, the breakeven inflation rate is 2.5% (4.0% - 1.5%). This means the market is “expecting” inflation to average 2.5% per year for the next 10 years. An investor would be indifferent between the two bonds only if actual inflation perfectly matched this rate.

Expected inflation is more than just a number for economists to debate; it's a critical variable in your investment calculus.

• Think in Real Terms: Always subtract expected inflation from your anticipated returns to understand how much your purchasing power is truly growing. A high nominal return means nothing if it’s wiped out by inflation.
• Seek Pricing Power: The best long-term investments in an inflationary world are often businesses that can raise prices without losing customers. A company that sells a unique, essential product is far better protected than one selling a generic commodity.
• Use Market Signals as a Guide: The TIPS spread gives you a powerful, real-time look at the market's collective forecast for inflation. Use it as a baseline. If your own analysis suggests inflation will be significantly higher or lower than what the market expects, you may have uncovered a valuable insight and a potential investment opportunity.