Believe those who are seeking the truth. Doubt those who find it. Andre Gide


Friday, January 17, 2014

U.S. Inflation Expectations: Low, But Rising

There's been a lot of talk lately about the threat of global deflation. According to Christine Lagarde, Managing Director of the IMF:
“With inflation running below many central banks’ targets, we see rising risks of deflation, which could prove disastrous for the recovery.”
And closer to home:
Ms Lagarde’s comments were echoed by Charles Evans, president of the Chicago Fed. “The recent news on inflation has not been good,” he said in a speech on Wednesday. “Inflation is too low and is running well below the FOMC’s 2 per cent target.”
Inflation in the U.S. is indeed running below target, but what about inflation expectations? Here are some market-based measures of U.S. inflation expectations (based on TIPS spreads) for two, five, and ten years out:


According to this data, inflation expectations in the second quarter of 2013 declined significantly at all horizons. The sudden jump down in expectations in the summer corresponds with the sudden rise in Treasury yields associated with the so-called "taper tantrum" following the June 19 FOMC meeting.

But it is interesting to note that immediately after the taper tantrum, inflation expectations recovered and stabilized, albeit at low levels (especially at the two and five year horizons). At the same time, nominal yields rose and remain elevated (with the 10 year hovering at or just below 3%).

What is even more interesting the reaction of inflation expectations after the December 2013 FOMC meeting, where the taper was actually implemented (the timing of which came as a surprise to most market participants). Short-run inflation expectations, in particular, appear to be on an upward trajectory. The effect is less evident at longer horizons.

I'm not going to offer any interpretation of what economic forces are at play here (I'll leave it up to you to offer your take on things in the comments section). One thing I can say though is that this data will provide at least a small measure of comfort to Fed policy makers concerned about the threat of deflation.

15 comments:

  1. I've never understood why so many people, economists, policy makers, etc., have a pathological fear of deflation. I think deflation is natural & desirable in a growing economy.

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    1. I'm with you Prof J. I think that a moderate inflation or deflation is no big deal, as long as it's steady and forecastable. Large and sharp movements in either direction are more problematic.

      Angela Redish and Michael Bordo, both excellent economic historians, have documented the "good and bad deflations" in U.S. history.

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    2. Thanks for the author recommendations. I found an NBER paper of their's - very interesting!

      And your point is well-taken: volatility is the real problem, as it screws up expectations and makes it harder to even form expectations.

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  2. Could it be Steve Williamson's model is right? It might be interesting to map Fed Funds futures against 2yr TIPS inflation expectations. Of course, correlation is not causality...

    This may have little to do with Williamson's model, but my thought is inflation pressure involves an increase in duration aversion. What I mean is, the last thing you want to hold if you believe inflation is rising is the a l.t. bond. The taper tantrum helped eliminate the "sure thing" nature of duration bets. This "sure thing" bet was, IMO, the biggest influence that QE had on market behavior. In other words, it constituted the Fed signalling to speculators that there was an arbitrage opportunity in buying duration and shorting bond volatility. Now that the arbitrage opportunity is gone, speculators seek to reduce duration in portfolios and hedge against an increase in bond volatility. This rebalancing arguably has inflationary effects.

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    1. Diego, working against the Williamson interpretation is the fact that the forward guidance was strengthened in the Dec meeting. But who knows, there are a lot of moving parts.

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  3. David-
    Could you expand on what exactly is shown on the graph? I'd imagine that the measures are some sort of TIPS spreads, but could you explain further?

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    1. Basically, just the Fisher equation: i = r + pi. We get i from nominal bond, r from inflation-indexed bond. The difference is interpreted as inflation expectation.

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    2. So, DGS10 minus DFII10, for example?

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  4. What to make of the 2-Yr and 10-Yr moving in relative parallel while the 5-Yr is odd-man-out (gap closing between 2-Yr and 5-Yr)? In fact, what does it mean if the 2-Yr and 5-Yr converge?

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    1. I'm not sure what it means. Keep in mind that these measures can move around for a lot of reasons. Probably a lot of noise.

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    2. I put the comment in the wrong spot:

      If I understand what is being plotted correctly, it implies that for the next five years the markets expect a small increase in inflation on average, with a bigger increase sometime between 5 and 10 years.

      The interpretation is similar to what the steepness of a yield curve would indicate about short term interest rates changing.

      Remember the plots are averages over a certain number of years (to an approximation). The 10 year average should include the earlier data, so that to get a 10 year average of 2.25, the latter half of the 10 years needs to be higher than 2.25 given lower inflation expected at the beginning.

      If the 2 and 5 years converge inflation would be expected to be constant on average over the next 5 years. Notice on the posted graph when in Apr 2013 2 year averages were higher than 5 year. That would indicate the market expects inflation to be higher on average in the two years after Apr 2013, than over the course of all five years as that would be the only wage for the five year average to be lower than the 2 year average. In other words inflation is expected to decrease.

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    3. James, that is a good analysis of the graph, and I agree with your interpretation.

      Though as far as inferences from a policy perspective, a few questions I have:
      Given a 2% target, all maturities converged at 2% would be a best-case scenario. As this isn't the case, is the Fed credible? Why/why not? Uncommitted or incapable? Expectations for yrs 5-10 are ~2.75%, which seems to me well beyond the stated target; does this worry the Fed?

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    4. This is something I have wondered about for the last two years, ever since I started teaching a money and banking class. Another couple possibilities: 1. opportune disinflation, while trying to avoid political flak, though I am not sold on this idea 2. fear of getting the QE exit strategy wrong, i.e. you know you have to get out of the hole you are in sometime, so you don’t want to dig too deep, 3. Steve Williamson’s model, which is why I found it intriguing even though it seems counterintuitive.

      2.75 does not concern me, in fact I find it reassuring that the market expects a return to somewhat normalcy. 2.75 is closer to normal over that last few decades than what we currently have:
      http://research.stlouisfed.org/fredgraph.png?g=rcx

      Which is why I am not sold on 1 and lean towards 2.

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