This article originally appeared in Institutional Investor on June 26.
Extracting economic information from asset prices is a difficult task. Yet it is likely worth the effort in the case of the collapse in the spread between Treasury Inflation-Protected Securities, known as TIPS, and the more common and mundane “nominal” U.S. Treasuries.
This spread is known as breakeven inflation (BEI) – in other words, it is considered the inflation compensation that investors command to move from TIPS to nominal Treasuries, since TIPS’ cash flows are contractually linked to the Consumer Price Index (CPI), a widely followed measure of U.S. inflation.
Earlier this year the breakeven inflation rate for five years starting in five years’ time declined further – it was already lower than levels seen in the financial crisis of 2008–2009 (see Figure 1). There are three possible explanations: Inflation expectations turned lower, investor preference shifted away from using TIPS to hedge inflation risk or the liquidity of the TIPS market decreased.
Recent Federal Reserve papers have suggested liquidity might be causing the decline in BEI. We disagreed, questioning in a March 14 blog post whether the Fed is missing this important market signal either due to a misunderstanding or due to a desire to convince market participants it can reach its goal. (PIMCO also published an in-depth paper on the issue in March this year.) We don’t think liquidity has deteriorated in TIPS because volumes are high by historical standards and transaction costs have been stable.
We see three reasons why the decline was due to a change in inflation expectations rather than a change in investors’ preferences.
1. The Fed’s cumulative miss on its own target
Since 25 January 2012, the Fed has set its inflation target at 2% as measured by the Personal Consumption Expenditures (PCE) index. The green line in Figure 2 shows what the core PCE index would look like if it were growing at the 2% target; the red line is the actual core PCE index. Core prices are 6% lower than where they should be if the Fed had reached its target. Clearly, the Fed’s recent record on meeting its inflation goal isn’t stellar. More importantly, low inflation can feed into low inflation expectations, which then feed into lower inflation.
2. It’s not the mode, it’s the distribution
Surveys and economists focus on the mode, i.e., the event that’s the most likely to happen, but perhaps they are missing some granularity in the distribution of inflation. What is the probability of getting no inflation or 4% inflation? A change in the distribution of inflation is as relevant as the mode, if not more.
It may well be that investors and economists agree that 2% is the most likely inflation rate for the next decade, but investors care about the distribution and may assign a higher probability to deflation risks than inflation ones. Indeed, options protecting for deflation risks are 20% more expensive than the ones protecting for inflation risks. Lower breakeven rates may well reflect a change in the distribution of inflation tail risks.
3. Global disinflationary forces
Excess capacity and weak demand globally have pushed commodity prices as well as inflation lower in most of the developed world and with U.S. trading partners. Europe and Japan are still battling deflation risks and China’s excessively leveraged economy could be another headwind. Divergence in inflation is possible, but a stronger dollar combined with low prices abroad will translate into lower import prices.
This doesn’t mean inflation expectations are stuck at low levels. Like the Fed, we see the most likely outcome for U.S. inflation as a rise toward the target, thanks in large part to a tight labor market. However, this isn’t yet a consensus view and we think low breakevens indicate that investors are more concerned with the Fed undershooting rather than overshooting its target. A good strategy to re-anchor inflation expectations would be to let inflation run slightly above the Fed target to compensate for the years spent under the target. The Fed seems more comfortable considering truly unconventional (and in our opinion counterproductive measures like negative interest rates) in order to boost inflation expectations rather than the far simpler approach of either stating that they would allow inflation to run above the 2% target, or equivalently, raising the 2% target itself as suggested recently by our Secular Forum speaker Olivier Blanchard as well as by former Treasury Secretary Larry Summers.
To sum it up, while the Fed officials may say they are targeting annual inflation of 2%, there are plenty of market participants who don’t believe they will reach that target.