Blog Post

The decline in inflation compensation

What’s at stake: While market measures of inflation compensation have declined on both sides of the Atlantic, Fed and ECB officials appear to have interpreted them differently. Fed officials dismiss these measures emphasizing the role played by changes in inflation and liquidity premiums. ECB officials appear, on the other hand, to have used these measures to warn against a possible disanchoring of inflation expectations. 

By: Date: February 2, 2015 Topic: European Macroeconomics & Governance

What’s at stake: While market measures of inflation compensation have declined on both sides of the Atlantic, Fed and ECB officials appear to have interpreted them differently. Fed officials dismiss these measures emphasizing the role played by changes in inflation and liquidity premiums. ECB officials appear, on the other hand, to have used these measures to warn against a possible disanchoring of inflation expectations.

Andrew Benito writes that although inflation compensation has fallen to a lower level in the Euro area, the recent fall in the Euro area is similar in size to that in the US.

Since Q3 2014

US

EA

Breakeven 5y5y

-0.50

-0.50

Survey (SPF) median 5 y23r

-0.11

-0.10

Survey (SPF) mean 5 yr

-0.15

-0.075

Survey vs. market-based measures

Jon Hilsenrath writes that Fed officials have been emphasizing over the past few months their preference for survey measures (for example Michigan’s Survey of Consumers, FRB Philadelphia’s Survey of Professional Forecasters, NY Fed Survey of Consumer Expectations, FRB Atlanta Business Inflation Expectations), which all display greater stability.

Marco Valli and Edoardo Campanella write that ECB officials have, instead, been emphasizing market-based measures more. In his Jackson Hole speech on 22 August, Mario Draghi openly stated that the 5Y5Y forward inflation is the key metric used by the ECB to gauge inflation expectations over the medium term. This was a surprisingly bold remark because the ECB has traditionally looked at a wider range of indicators, including survey measures. Real Time Economics writes that the deterioration in inflation expectations was instrumental in the decision of the ECB to embark in a large program of asset purchases.

Breakeven = Expected inflation + Inflation Risk Premium – Liquidity Risk Premium

A decrease in the breakeven rate can be driven by a decrease in expected inflation, a decrease in the inflation risk premium and/or an increase in the liquidity risk premium. To see that, note that:

·         Nominal Yield on Treasury = Real Yield + Expected Inflation + Compensation for Inflation Risk

·         Nominal Yield of TIPS = Real Yield + Compensation for Liquidity Risk

·         Breakeven inflation = Nominal Yield on Treasury – Nominal Yield of TIPS = Expected inflation + Inflation Risk Premium – Liquidity Risk Premium

Source: NY Fed, Survey of Primary Dealers

Tim Duy writes that the Fed does not believe market-based measures of inflation expectations as indicative of actual inflation expectations. In fact, the Fed does not refer to these as "expectations" measures and calls them inflation "compensation."  They are trying to tell us very clearly that TIPS are not giving a measure of pure inflation expectations. They do not want those measures by themselves to affect market expectations of the path of monetary policy.

Janet Yellen said in her latest FOMC press conference that “[this decline] could reflect a change in inflation expectations, but it could also reflect changes in assessment of inflation risks. The risk premium that’s necessary to compensate for inflation, that might especially have fallen if the probabilities attached to very high inflation have come down. And it can also reflect liquidity effects in markets. And, for example, it’s sometimes the case that— when there is a flight to safety, that flight tends to be concentrated in nominal Treasuries and could also serve to compress that spread. So I think the jury is out about exactly how to interpret that downward move in inflation compensation.

Juan Angel Garcia and Thomas Werner write that at long horizons, the dynamics of inflation risk premia mimics closely the dynamics of inflation skewness rather than inflation variance. Downside inflation risks (negative skewness) indicate that there is a higher probability of inflation turning out below rather than above the mean expectation. Investors perceiving downside risks therefore face lower risk that inflation erodes their nominal returns and are likely to request a lower premium to hold nominal assets.

Oil price decline and TIPS

Tim Duy writes that the view of market-based measures of inflation expectations as distorted by the massive drop in the price of oil is not illogical: There is no reason to think 5y5y forward exceptions to be impacted in lock step with the collapse in oil prices.

Andrew Benito writes that even if the recent fall in oil prices is permanent, it should not have a permanent effect on inflation rates, and thus inflation expectations, over the medium term. The recent fall in oil prices will fall out of the annual CPI inflation rate in a year’s time. And, even allowing for lagging, indirect effects from oil prices on the prices of other goods and services, it would be unusual for such effects to persist beyond the next five years. 


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