Wednesday, October 27, 2010

Will The Market's Inflation Expectations Prove Accurate?

Expectations of quantitative easing has increased market expectations of inflation according to the proxy of yield spread between nominal and inflation-indexed Treasuries. As a result, deflation risk appears to have fallen, although there is uncertainty in the level of quantitative easing that will take place. See the following article from The Capital Spectator for more on this.

It’s important to distinguish between “good” and “bad” deflation, the former being a byproduct of improved technology, higher productivity, and other factors that can generally be lumped under the heading of “progress.” Bad deflation, by contrast, is the blowback from a shock of one form or another that produces a financial crisis, such as the one that occurred in 2008.

In those cases when deflation threatens, it's almost always a problem when it's triggered by a financial crisis. Several centuries of history speak loud and clear on this point. But is the threat from deflation limited to those instances when broad measures of prices are currently falling? Not necessarily. The fear of future deflation, even when prices are stable or still rising, can be harmful too. Expectations in economics, after all, can become a self-fulfilling prophecy, particularly when it comes to broad trends in prices.

No less is true for inflation/deflation expectations. In fact, this is where the monetary rubber meets the road. As a recent New York Fed monograph reminds, “monetary economists have emphasized the importance of longer term inflation expectations, and recent literature suggests that the containment of long term inflation expectations is the most important objective in conducting monetary policy.” No less is true if worries about deflation lurk.

The challenge is measuring expectations. At best, it's a difficult task. One tool is looking at the yield spread between nominal and inflation-indexed Treasuries, a proxy for inflation expectations. It's an imperfect gauge, but it does capture some degree of how the crowd's thinking about the inflation/deflation outlook. By this standard, there's reason to think that the outlook for prices has stabilized recently, as the chart below shows. The market's forecast for inflation on Friday was roughly 2.1%--up from the recent low of around 1.5% in late-August. The general view, in other words, appears to be that the Federal Reserve's talk of a new round of quantitative easing (QE2) has short-circuited falling inflation expectations. Yes, that's premature. We'll need to see the Treasury's inflation forecast remain steady for some length of time. But for the moment, a bit of optimism is in order.

Will the crowd's prediction turn out to be accurate? There's reason to think so, given what researchers have told us about the connection between inflation expectations and actual price changes. But there are caveats. One is that there's a lag between the market's inflation prediction and the actual reported rate of consumer inflation. The current update on consumer prices runs through last month, and the latest number advises that inflation's pace was still falling through September. Deciding the efficacy of monetary policy on battling deflation anxiety in terms of actual price changes will take time.

There's also the issue of the Fed's tough talk on rolling out QE2. When will it arrive exactly? How potent will it be? How long will it last? Will it really have an impact on the actual level of inflation?

Deflation may or may not persist, but that’s largely a function of the policy response. As economists Richard Burdekin and Pierre Siklos point out in Deflation: Current and Historical Perspectives““, “sustained deflation is only possible when the rate of money growth falls behind the rate of growth of output and money demand.”

For the moment, there's reason for thinking that the deflation threat isn't as strong as it appeared in August and September. Does that mean that the Fed has achieved its goal and will now minimize QE2? If so, will the disinflation/deflationary march resume?

Lots of questions these days with relatively few answers in real time. The Treasury market's inflation outlook is one exception, but it's far from the last word on where inflation's headed. But the fact that commodity prices have been rising lately, including gold, suggests that the Treasury market's inflation forecast is more than noise.

This post has been republished from James Picerno's blog, The Capital Spectator.

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