Monday, 10 August, 2015
Market expectations for U.S. inflation appear to be sagging again. This could complicate the Federal Reserve’s deliberations about raising short-term interest rates as soon as September, though the central bank’s earlier reactions to similar movements suggest that by itself it won’t derail a move.
Yields on 10-year Treasury notes have dropped from near 2.5% in mid-June to 2.16% on Friday, a sign investors demand less compensation for expected inflation than a few months ago. In Treasury Inflation-Protected Securities (TIPS) markets, where expectations can be measured more precisely, the compensation that investors demand for expected inflation in five to ten years dropped to 2.01% on Friday, down from 2.25% in late June, according to estimates by Barclays. These premiums are near where they were when the Fed started signaling its second round of bond purchases in 2010 and they are lower than they were when the Fed launched its third round in 2012. Nearer-term measures of inflation compensation in TIPS markets are under 2%.
Fed officials have said they want to be reasonably confident that inflation will rise toward 2% before they start raising short-term interest rates. Official measures of inflation have run below the target for more than three years. It is hard to see how falling inflation compensation in bond markets adds to that confidence. Still, the Fed has a complicated relationship with the whole idea of inflation expectations. As a result these bond market measures can’t be extrapolated straight into Fed actions.
In theory the central bank places great weight on where investors, households and business believe inflation is heading. Expectations can become a self-fulfilling prophesy. When inflation expectations rise sharply — as happened in the 1970s — households and businesses can demand more compensation in anticipation of a move up and push prices up in reality. When the reverse happens and expectations fall, it could become a weight on inflation.
In 2010, in the lead-up to the Fed’s decision to launch a second round of bond buying, drooping measures of expected inflation in bond markets got their attention, in part because these measures were coupled with a weak economy and still very high unemployment. The jobless rate in the summer of 2010, when the Fed started signaling moves toward a second round of bond purchases, was near 9.5%. It was 5.3% in July.
When inflation compensation in bond markets moved down again last year and stayed low early this year, Fed officials took a highly nuanced view. They noted independent survey measures of households, such as by the University of Michigan, showed inflation was expected in the public’s mind to stay stable. The distinction between surveys and markets has made its way into Fed policy statements. Bond market measures, officials have added, were being influenced by transitory movements in oil prices. In a press conference in December, Fed Chairwoman Janet Yellen drew a distinction between the inflation that investors actually expect and the premiums they demand for the risk of inflation. Her suggestion was that market risk premiums might fall for reasons other than shifts in expected inflation. The broader point was that Fed officials, though watching shifts in market expectations for inflation, weren’t getting very alarmed about it the downdraft.
Drops in market measures of expected inflation now could well make officials more reluctant to move aggressively once they have started pushing up short-term interest rates this year. But given their response earlier this year, it would probably take a much bigger move, or other signs of a shift in the economic outlook, to make them rethink their plans for a first increase.
— Jon Hilsenrath
Alan "Ginger" Taylor
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