How firms’ inflation expectations impact the Fed’s mandate

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Why are firms’ inflation expectations important economic indicators?

Inflation, in general, has a direct bearing on interest rates. Other factors remaining constant, the higher the expected rate of inflation, the higher the required rates of return on both debt (AGG) and equity (VOO) investments, and vice versa. This is because inflation erodes the purchasing power of money, as, with higher inflation, larger nominal amounts of money are required to purchase the same quantity of goods. So investors demand a higher rate of return as compensation for any expected erosion in their future returns due to inflation.

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In this context, firms’ inflationary expectations play an important role. Firstly, inflationary expectations help firms in their pricing and cost control decisions, which help maintain margins and returns to shareholders. Secondly, the pricing decisions made by firms impact the whole economy. Pricing decisions, in turn, are determined by inflationary expectations. Thirdly, the Fed’s mandate of maintaining inflation at about the 2% level can be influenced by firms’ inflation expectations. The Fed measures inflation as the annual change in the Price Index for personal consumption expenditures. Firms’ inflation expectations can provide valuable feedback to policy makers if they exceed or fall short of the Fed’s long-term inflation target of 2%. In this context, the Atlanta Fed’s Business Inflation Expectations (or BIE) Survey helps measure firms’ inflation expectations.

Inflation impacts almost all sectors of the economy, affecting both stocks and fixed income investments. ETFs that have exposure to a broad-market stock index include the Vanguard S&P 500 ETF (VOO), which tracks the S&P 500 Index. The index is market-cap weighted and tracks the performance of the 500 largest companies in the U.S., from a cross-section of industries. With an expense ratio of 0.05%, the top ten holdings in VOO include consumer packaged goods maker Proctor & Gamble (PG) and financial services company JP Morgan Chase (JPM).

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ETFs investing in fixed income securities include the Core Total U.S. Bond Market ETF (AGG), which tracks the Barclays U.S. Aggregate Bond Index. The index measures the performance of the U.S. investment grade bond market, investing in a wide spectrum of public investment-grade taxable fixed income securities in the United States—including government, corporate, and international dollar-denominated bonds, as well as mortgage-backed and asset-backed securities, all with maturities greater than a year.

Inflation is also likely to significantly affect floating rate ETFs like the iShares Floating Rate Bond (FLOT) ETF, which tracks the Barclays Capital <5 Years Floating Rate Note Index that measures the performance of U.S. dollar–denominated investment-grade floating-rate notes. Increases or decreases in inflation expectations would result in increases or decreases in floating interest rates at their interest reset dates.

To find out about the key highlights of this month’s Atlanta Fed Business Inflation Expectations Survey, read on to Part 2 of this series.

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