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The Federal Reserve isdetermined to push inflation higher from levels it considers dangerously low. For that to happen, it must first convince everyone that prices will accelerate in coming years.
One big problem is that the measures that bond traders and strategists rely on for longer-run inflation expectations can often give conflicting and confusing signals. No one can agree on how best to use or decipher them, with even the Fed seemingly reticent to narrow it down; its economists recently reviewed a cocktail ofmore than 20 gauges. Yet depending on which measure is considered, inflation is still well short of the Fed’s average 2% goal — or may have already exceeded it.
With the Fed planning to keep rates near zero until price pressures re-emerge, it’s a far from academic question. The prospect of an abrupt economicreflation lifted yields on U.S. debt to the highest in months this week, skewing the yield curve to near its steepest in four years and bringing forward bets on rate increases. While those bets dipped amid stop-start talks over a stimulus package, theirresilience was a timely reminder for traders of what’s at stake in nailing the outlook for inflation.
“The Fed needs to look at everything, all of these measures,” said Roberto Perli, a partner at Cornerstone Macro LLC and a former Fed economist. “They have developed models to be a little bit more discerning” in how they read market-based inflation expectations, “but you can’t trust the models completely either, as models can be wrong,” he said.
For better or worse, this imperfect soup of frameworks, surveys and metrics is now at the heart of the Federal Reserve’s monetary policy. Central bankers believe the public’s expectations for inflation ultimately govern how high officials are able to lift rates. Yet gauges of the outlook have been too low for the Fed’s liking for years.
That concern played into its decision in 2018 toreview policy making, and the central bank now plans to keep rates low until price gains average 2% over time, contingent on longer-term inflation expectations also remaining well anchored at that level.
“Inflation expectations have always been important to the Fed’s approach, but this new framework puts them front and center, in that the changes are aimed at keeping inflation expectations at 2%,” said Brian Sack, director of global economics at D.E. Shaw & Co. and former head of the New York Fed’s markets group. “That makes measuring those inflation expectations — as best can be done — even more important.”
The question, then, is how to go about that.
No Easy Answer
Probably the most widely known yardstick is the so-called breakeven rate, which measures the gap between yields on Treasury Inflation-ProtectedSecurities, or TIPS, and standard Treasuries. Reflecting the average level of the consumer price index that would make the payout from any investment in these bonds roughly comparable over their lifetime, the 10-year breakeven rate is currently 1.73%, up from an 11-year low of 0.47% in March. It hasn’t consistently held above 2% since 2018.
But most analysts say those numbers can’t be taken at face value. The relativeilliquidity of TIPS can depress prices, while the risk premium that investorsseek because of uncertainty about inflation can also weigh on breakevens. Fed staffers havedeveloped models to adjust for these variables.
“We didn’t ever suppose that one could simply subtract the TIPS yield from the nominal Treasury bond yield and have the best possible indicator of inflation expectations,” said former Treasury Secretary Larry Summers, who wasinstrumental in TIPS’ 1997 debut. “Nonetheless, almost everyone would tell you that movement in the indicated inflation rate over time is telling you something important about the magnitude of market concerns about inflation.”
Still, since the early 2000s, the Fed hasfocused more on forward markets, favoring what’s known as the five-year, five-year forward breakeven rate — traders’ projection for the rate in half a decade. The rate, which cuts out some of the short-term noise that affects consumer prices, was about 1.69% as of early October, and it too has been well below 2% for the past two years.
D.E. Shaw’s Sack, who helped convince the Fed to focus on forward measures of long-run inflation expectationsduring his time at the central bank, says he expects policy makers to be ready to begin removing accommodation in four or five years.
The Fed also monitors polls of economists and consumers for a more human lens on where inflation is heading. The Philadelphia Fed’s most recent quarterly Survey of Professional Forecasters showed a decline in expected annual inflation over the next decade to 1.85%, after being generally well-anchored at 2%, while surveys of households conducted by the University of Michigan and the New York Fed suggest expectations remain above that level but have been falling for years.
And then there’s the broader bond market.
“It wasn’t that long ago that most of us would kind of say, ‘What’s the 10-year Treasury rate doing?’ Because when 10-year Treasury rates go up, oftentimes inflationary expectations are moving up,” Chicago Fed President Charles Evans told reporters on Sept. 23. “It’s under 1% — this does not at all seem consistent with strong inflationary expectations.”
Little wonder, then, that a recent spike in yields prompted some to reassess that outlook.
Investors and policy makers will get the latest read on inflation next week when indexes of consumer and producer prices are due to be released. Several central-bank officials including Fed Vice Chair Richard Clarida are also slated to speak, potentially providing further detail on how they see price pressures evolving.
Still, Wall Street seems to have already taken heed of policy makers’ revised approach. The Fed’s new framework itself has helped boost expectations for inflation in recent months, according to market participants referenced inminutes from the Fed’s September meeting.
“What’s going to inform the Fed’s view of inflation is where long-run inflation expectations are,” said Michael Gapen, chief U.S. economist at Barclays Plc, who sees the Fed on hold until about 2025. “How long they overshoot and how much they let inflation rise above 2% will be dependent on the behavior of those long-run inflation expectations.”
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