Alarms are ringing over how much expected inflation has fallen in recent months. Bond markets are betting that five to 10 years from now, inflation will be roughly half the Fed’s 2% target. The University of Michigan reports on household expectations today; its last survey found long-term expectations hit an all-time low earlier this month.
This has unsettled some Federal Reserve policy makers and many outside analysts, because low expectations can be self-fulfilling. It’s fueled calls for the Fed to stop raising rates, or even cut them.
But the drop may be misleading: It is heavily driven by falling oil and gasoline prices. While inflation is too low, the reality is not nearly as bad some in the market think, and they could be in for an unpleasant surprise if oil prices stabilize or head higher.
A one-time change in the price of oil can push inflation up or down in the short run but in theory those effects should fade over time. That’s why central bankers monitor measures of expected inflation some years in the future.
Yet contrary to theory, oil prices do affect long-term expectations. The daily correlation between oil prices and the market’s expected inflation rate in five to 10 years’ time is 30%, according to Michael Feroli of J.P. Morgan JPM +1.27%, and statistical tests strongly suggest that isn’t just random noise. “We are talking about a pretty strong relationship that can only be rationalized…with some very extreme (arguably bizarre) stories about what oil tells us about the 2020-25 inflation outlook,” he says.
Perhaps investors assume that whatever is driving oil down is going to have a lasting effect on all other prices and wages, such as the deflationary impact of a China slowdown. But underlying inflation trends are not deteriorating. Core inflation, according to the consumer-price index, reached 2.3% in January, the highest in three and a half years. Earnings growth has moved up gradually in the last year.
Yields on inflation-indexed bonds are heavily driven by technical factors, such as higher demand for ordinary Treasurys at times of market turbulence, the tendency of prices to rise more in the first than the second half of the year, redemptions, and hedging against oil-price changes. Three economists at the Atlanta Fed show that when oil prices go down, that artificially reduces the inflation rate indicated by the difference in yields on indexed and regular bonds. Those yields currently imply CPI inflation will average about 1.4% between five and 10 years from now, or 1.1% if the Fed’s preferred price index of personal-consumption expenditures is used.
Energy prices have a similar, though less extreme, effect on household attitudes. Economists at Goldman Sachs GS +1.81% note that long-term inflation expectations as surveyed by the University of Michigan are highly correlated to gasoline. The drop in this measure should be no surprise given the epic collapse in pump prices since 2014. If gasoline stops falling—it doesn’t actually have to rise—households’ long-term expectations should recover.
Importantly, that’s not the same as saying they’ll rebound to something more normal. Both overall and underlying inflation have persistently run below the Fed’s 2% target in recent years and odds are that will continue—though not by as much as the bond market thinks. That wages have only begun to stir with unemployment now below 5% illustrates how little pressure there is on the economy’s capacity, and how little urgency there is for the Fed to pre-empt a dangerous wage-price spiral.
That said, neither the Fed nor anyone else need panic over the recent drop in inflation expectations. The Fed may well decide to pause in its rate-normalization campaign. But the decision on whether to abort that campaign altogether can wait until a clearer picture of inflation and economic growth emerges in coming months.
source: The Wall Street Journal