Understanding Memory Inflation and its Impact on Bond Yields
The Mayo Clinic describes Post Traumatic Stress Disorder (PTSD) as a mental health condition triggered by an extremely stressful or terrifying event. Within PTSD research, there's a concept known as "memory inflation", which refers to the intensification of traumatic memories over time.
Memory inflation can amplify emotions and behaviors. As will be discussed, the distress from recent price inflation is leading many investors to fear a recurrence of a similar situation. Due to the close relationship between inflation and bond yields, memory inflation can negatively impact bond prices. It may also prevent some investors from recognizing an opportunity to profit from distorted market views.
How Apollo Management's Chart Crime Fuels Memory Inflation
A graph from Apollo Management has been circulating on social media for almost a year. This graph seems to keep the high inflation of the past fresh in people's minds, thereby fueling memory inflation and distorting investors' current perception of inflation.
The graph suggests that inflation is closely following the pattern of the 1970s and 1980s. This prompted the creation of a four-part article explaining why the current environment is vastly different from the 1970s and 1980s. The series strongly argued that another round of inflation is unlikely, barring an unforeseeable black swan event.
A more accurate graphical comparison between the two periods was created, highlighting why the original graph is deeply flawed. The two vertical y-axis scales on Apollo’s graph are different, which makes it seem like the inflation rates of the 1970s and today are almost identical. Additionally, the horizontal axis doesn't provide a fair comparison. The recent data for comparison should start in 2020, not six years prior, when there was little inflationary impulse.
Inflation Rates Versus Price Levels
When people discuss inflation, they often talk about how the prices of many goods and services are much higher today than a few years ago. However, these statements reflect the price differences between today and the past but do not reflect the recent rate of change.
Economists, when discussing inflation, will note the annual or monthly rate of change and not the absolute price level. This difference in perspective between economists and citizens can lead to different views on inflation.
Bond Investors Should Adopt an Economist's Perspective
Whether logical or not, memory inflation of inflation creates fear of another inflation bout. For bond investors, this can create an opportunity if they believe, like the Federal Reserve and others do, that inflation is heading back towards 2% and will likely stay there, barring an unforeseen event.
Bond investors should always seek a yield that compensates them for inflation and credit risks. The higher the perceived risk, the greater the yield. Memory inflation of inflation subconsciously pushes many investors to demand higher bond yields. This condition will persist. However, assuming inflation continues to head towards or below the Fed’s 2% target, the fear will diminish over time. As it fades, bond yields will align with inflation rates.
The Fed is also Affected by Memory Inflation
If you're concerned that your inflation worries will persist even as evidence strengthens that inflation is fading, you're not alone. The Federal Reserve also has the same problem.
As of September, the Fed’s long-run GDP and PCE price forecasts are 1.80% and 2.00%, respectively. In 2019, before the pandemic, the Fed’s long-range forecast for GDP was 1.90% and PCE at 2.00%. Despite virtually identical economic and inflation outlooks, the lowest long-range Fed Funds rate forecast for the 19 Feb members is 2.40%, well above the average Fed Funds rate in the post-finance crisis era.
Bottom Line
Memory inflation of inflation results in bond yields trading above where they might have been had the recent bout of inflation not occurred. It also results in a relatively conservative monetary policy.
Memory inflation won't disappear overnight, but as the distress of higher inflation ages, the bad memories will subside. Could we say memory disinflation will kick in?
Historically, bond yields have a solid relationship with inflation and economic growth. Considering that today's economic fundamentals are not much different than before the pandemic, one might question why bond yields remain high. Some will blame the massive deficits or foreign selling of Treasury bonds. However, it's believed that a lot of the yield premium rests on the shoulders of memory inflation and not the truest fundamental driver of yields, actual inflation.
What are your thoughts on this topic? Do you think memory inflation is a significant factor in the current state of bond yields? Share this article with your friends and discuss it further. Don't forget to sign up for the Daily Briefing, which is delivered every day at 6pm.
Understanding Memory Inflation and its Impact on Bond Yields
The Mayo Clinic describes Post Traumatic Stress Disorder (PTSD) as a mental health condition triggered by an extremely stressful or terrifying event. Within PTSD research, there's a concept known as "memory inflation", which refers to the intensification of traumatic memories over time.
Memory inflation can amplify emotions and behaviors. As will be discussed, the distress from recent price inflation is leading many investors to fear a recurrence of a similar situation. Due to the close relationship between inflation and bond yields, memory inflation can negatively impact bond prices. It may also prevent some investors from recognizing an opportunity to profit from distorted market views.
