The Federal Reserve’s leadership often has said it is monitoring economic and market data as it decides on policy. The question is: When it comes to inflation expectations, is the Fed coming to the right conclusions?
To be sure, extracting economic information from asset price changes is often difficult because price moves not only imply changes in economic expectations but also changes in the uncertainty around them and in investor preferences, which together constitute the risk premia investors demand. In addition, one has to factor in liquidity premia related to the ease of owning the asset and frictions involved in trading it.
For example, changes in equity prices could mean either a change in earnings expectations or a change in the equity risk premium (uncertainty around the earnings expectations and investors’ risk aversion) or changes in the liquidity premium (the cost of owning the equities or of trading them). Analogously, changes in corporate bond spreads could be due to changing default risk, changing uncertainty around the default risk or changes in the liquidity profile of corporate bonds.
Similarly, the spread between Treasury Inflation Protected Securities (TIPS) and maturity-matched nominal Treasuries, known as the breakeven inflation (BEI) rate, could move because of changes in inflation expectations, uncertainty about inflation expectations and changing preferences for owning inflation-hedging assets (risk premium) or changes in the relative liquidity between TIPS and nominal Treasuries. Recently, the BEI rate for five years starting in five years’ time collapsed to levels not seen even in 2008.
The question then is whether this collapse was due to falling inflation expectations, changes in the risk premium or changes in the liquidity premium. The Fed has repeatedly suggested that the change in breakeven inflation rates is most likely due to a large liquidity premium in TIPS, citing research by the Federal Reserve Board and Atlanta Fed, and has concluded that inflation expectations were stable. We would consider this credible if the BEI in the TIPS market was falling in isolation. However, when this fall in BEI is accompanied by falling equity markets, widening credit spreads and increased market volatility, one has to wonder about the methodology used to conclude that the fall is most likely due to liquidity issues.
In order to test this hypothesis, we did our own study at PIMCO – we intend to publish a paper on this in the coming weeks – where we conclude, counter to the Fed, that it is unlikely that the collapse in BEI rates was due to a liquidity premium. The collapse was either due to falling inflation expectations or an increasing risk premium and associated uncertainty around the inflation forecast. Both of these should lead the Fed to be nervous about achieving its inflation goal, which it has missed for the last several years. Instead, the Fed, citing the research referenced above (along with stability in survey-based measures, which themselves have recently fallen), seems to be sanguine about the possibility of inflation expectations settling in well below target. While our approach is slightly different from that taken in the Fed’s research, we point out one issue with the Fed’s analysis (warning technical details ahead): the fitted coefficients of the variables in the model used by the two Fed papers cited make it difficult to conclude anything other than the fact that inflation expectations are stable. To put it differently, if inflation expectations were not stable, we feel reasonably confident that the model would wrongly attribute the change in inflation expectations to liquidity.
The Fed has been trying to explain recent market moves and volatility while rejecting the idea of lower inflation expectations or at least an increased preference for assets that are traditionally used to help protect against deflation. Its conclusion is something along these lines: low BEI in longer-dated TIPS is due to illiquidity and also irrationally correlated to low oil prices (investors can be irrational at times). Low oil prices can be explained by a supply shock. Low nominal rates in the U.S. are due to a negative term premium, which could be due to low global rates (but not that the market may legitimately expect the federal funds rate to peak at 2%). The Fed seems to be dismissing the possibility that the narrative could well be that diminishing monetary policy returns as well as tighter monetary policy in the U.S. despite years of sub-target inflation and global inflation headwinds have pushed inflation expectations lower. Logically, sub-target inflation expectations with rates already so close to zero would translate into lower commodity prices, lower BEI, lower nominal rates and a higher risk premium across assets.
We believe the Fed’s dismissal of market-implied breakeven inflation rates may have increased volatility in the markets due to a loss of faith in either the Fed’s understanding of market signals or its desire to achieve its inflation goal. Confidence in the Fed’s analysis of market and economic data and its objectives is a key to successful monetary policy. We believe the Fed may have undermined this by choosing to ignore signals from the TIPS market.
Institutional investors and investment professionals, click here for an in-depth PIMCO study on Breakeven Inflation mentioned above.