The yield on the 10-year Treasury Note was under 2.5% this morning at one point—the lowest since early 2009 and down sharply from this past April’s 4% range. Not surprisingly, inflation expectations are falling too. The market’s outlook for inflation slipped below 1.5% yesterday for the decade ahead, based on the yield spread between the nominal and inflation-indexed 10-year Notes. The last time this inflation forecast was so low was July 2009.
Deflation is still a ways off—150 basis points, by the measure of 10-year-yield spreads. But it’s not the level per se that’s the key worry. Rather, it’s the trend. For the last four months, the Treasury market has been telling us that inflation expectations have been falling. Maybe this rising anxiety is wrong. Maybe it’s a bubble. Maybe the market’s irrational and prices don’t matter about the future. Maybe, but maybe not. Unless you’re clairvoyant, the trend can’t be ignored, at least not entirely.
Clearly, something’s up (or down) with inflation expectations. The main reason to think twice before dismissing the market’s outlook is that corroboration has been arriving in other economic measures for several months. Yesterday’s dramatic fall in existing housing sales is the latest sign that the economic recovery is weakening.
In fact, the drop in home sales provides a timely lesson for divining the future with inflation. One catalyst for the slump in housing sales last month was the expiration for the home buyer tax credit. This one-time stimulus gave the market a boost, or so it seems, but the juice evaporated big time in July.
The lesson is that expectations are a critical factor when it comes to economic rebounds and related matters with prices. It’s relatively easy to convince the crowd for a time to spend or to assume that prices will change in a given direction. But if the market thinks the stimulus will soon end, the effect is likely to do little more than borrow future consumption by moving it forward. In that case, today’s higher consumption will be paid for with lower consumption tomorrow.
Something similar applies to inflation expectations. If you’re trying to raise inflation expectations, or at least stabilize them, the effort must be credible. Quite a bit of economic research tells us no less. To be sure, there’s “substantial disagreement” about inflation expectations, as a study from Stanford a few years ago reminds. On the other hand, it’s also clear that inflation expectations in various forms provide a fairly reliable clue about the actual levels of future inflation, as shown in a chart from the study that’s republished below.
Are inflation expectations always accurate? No, of course not. What’s more, there’s more than one way to measure the market’s outlook on price trends. But given the broad economic backdrop of late, we should be reluctant to ignore the Treasury market’s ongoing forecast of falling inflation. This decline isn’t an isolated event.
The solution at the very least requires stabilizing the market’s inflation forecast. Allowing it to continue falling would eventually lead us into dangerous territory with deflation. Yes, the risk of higher inflation—even runaway inflation—down the road is a threat, and one that we can’t forget. And that challenge makes the Fed’s job in the here and now all the more precarious. But unless you’re willing to overlook the current economic slowdown, inflation isn’t a clear and present danger today, nor is it likely to be a pressing concern for the foreseeable future.
If the Federal Reserve has any chance of stabilizing inflation expectations it must do so with a credible policy, which is to say a policy that the market takes seriously. As the housing market’s sharp fall reminds, that’s not so easy with one-time prescriptions that the crowd recognizes will soon fade from the scene. That suggests that the Fed needs to communicate with the market that it will move heaven and earth to keep inflation expectations from falling any further. Arguably those expectations should target headline inflation at a level that’s higher than current ~1.5% outlook for the decade ahead.
Surely no one thinks the central bank should let the market’s expectations for inflation fall to 1% or lower. At some point even the inflation hawks will concede this point. The danger is that when they do, it may be too late to arrest the current trend.
Fed chairman Ben Bernanke is scheduled to speak this Friday at Kansas City Fed’s annual Jackson Hole conference. This is the next opportunity to lay the groundwork for stabilizing the market’s inflation expectations. If not then, when?
Time is running out. The longer the market anticipates that the risk of deflation is rising, the harder it will be for the central bank to dissuade the crowd from this expectation. Remember, too, that it doesn’t really matter what actual inflation was last month, or over the past year. The main priority is managing expectations.
The Fed still has enormous power over the market’s outlook on general price trends. The question is whether the Fed will rise to the occasion. Don’t hold your breath. Indeed, there’s quite a bit of internal debate at the Fed these days, as The Wall Street Journal reported yesterday. The “deep divisions” about how to manage monetary policy is unfortunate, but it’s reality. No wonder that the market continues to assume that inflation will fall.
Until (or if) the Fed acts convincingly to change expectations—or if economic reports turn sufficiently bullish in the weeks ahead—more of the same is coming: lower interest rates. Momentum is a powerful force in financial markets, just as inertia has been known to dominate central bank decisions at times. This seems to be one of those times.