Upside Surprise: What The Inflation Skew Prices In

Inflation is low, has been so, and is forecast that way for a while. I mostly agree. Nevertheless, let's look at the other possibilities. Below is a picture that captures what is driving the headline inflation in the US. Yes, no surprise here, it is the oil price.

If we take out that part though, things looks interesting. As we can see, a large contribution comes from housing. Most will perhaps agree the oil related part is transitory. So the real question is what about the housing. At this point it seems within the dual mandate of the Fed, the unemployment part as just a target number becomes less relevant. It is at 5.1%, can go down to 5.0% or go up to 5.2%, or there can be serious debate about what is the level of NAIRU. But the fact of the matter is over the past few decades the revered Phillips curve has weakened a lot. With a drop in productivity, and labor share of GDP, the unemployment number is a lot less related to inflation now. So for policy makers the real points are two-folds - look out for signs of wage inflation, and also look out for heating up of the housing markets (or risk premia compression in general). And so far we do not have any strong confirmed signs of any. Unfortunately the action of the Fed has a certain lag on the policy targets. So to move in after seeing confirmed signs of these may be too late. Which means a slow and steady path of hikes replaced by a delayed and steep one.

The market seems to seriously be thinking over it. These is based on the volatility markets of the US inflation. Which trades typically as zero coupon swaps on the CPI (urban) index and options on that. The chart below shows the implied vol of a 5y options at a 2% strike (blue), the vol premium (green, implied vol over the actual realized vol of the index) and the skew (red, difference in vols between a 2% and a -1% strike on right hand axis, note: these vols are approximate and implied from Bloomberg quoted price)

The inflation vols has picked up a bit recently (but nowhere near the paranoid inflation phobia in 2009 - 2010 following the QE), but the vol premium has shrunk has well. The strong negative skew since 2013 correctly predicted/ coincided with increasingly softening inflation expectation, and maintained the negative skew till very recently. (Apart from a short flare up of headline inflation in Q2 2014, which the Fed rightly called the bluff). But this is now almost reversed and poised for a come back on the other side. It seems although market is not much upbeat about the breakeven inflation forwards, it is increasingly suspicious of a further downside surprise. Contrast this with the vol markets nominal rates (USD swaptions), where the skew is now flipped on the receiver side for a while.