San Francisco Fed: Market-Based Inflation Forecasts Are Lousy

If Janet Yellen wants to know where inflation is going, she shouldn't ask the market.

Why Fed Officials Still See a 2015 Liftoff

Financial markets are suggesting that the Federal Reserve is not on track to hit its inflation targets soon.

For monetary policymakers who want to be reasonably confident that inflation is set to return to their 2-percent target, the renewed slide in five- and 10-year breakeven inflation rates in the second half of 2015 offers no cause for reassurance:

Bloomberg

One- and two-year inflation swap rates tell a similar story: Market participants don't expect firm inflation soon.

To some, the decline in market-based measures of inflation is an argument against an imminent interest rate hike by the Fed.

But what if market-based measures of inflation expectations are just noise?

In a recently released Economic Letter, Michael D. Bauer and Erin McCarthy of the San Francisco Federal Reserve's economic research department find that many factors prevent market-based measures of inflation from being a true gauge of how the market expects price pressures to evolve, ant that severely hamper the predictive power of these metrics.

"For example, they include a risk premium to compensate investors for inflation uncertainty and are affected by changes in liquidity, unusual demand flows, and, more broadly, 'animal spirits' that change prices but are unrelated to expectations," the pair write. "Hence it is unclear how much useful information they provide and how much one should pay attention to these rates when forecasting inflation."

Bauer and McCarthy refer to previous research that found survey-based forecasts, such as the Philadelphia Fed's Survey of Professional Forecasters and the Blue Chip Financial Forecasts, compare very well against other models that attempt to forecast inflation. The pair reached a similar conclusion after performing their own analysis.

Over one- and two-year time frames, inflation swaps have a worse forecast performance than these surveys, holding the current level of inflation steady or assuming that inflation will meet the Fed's target, the researchers find.

San Francisco Federal Reserve

You can see from the above chart that inflation swap forecasts (in green) are, to the naked eyeball, incredibly reactive to realized inflation rather than forward-looking.

"We find that market-based measures of inflation are poor predictors of future inflation," conclude Bauer and McCarthy. "Idiosyncratic market forces and inflation risk premiums appear to be important drivers of market-based inflation expectations."

Another common critique of market-based measures of inflation expectations is that they are overly influenced by fluctuations in the price of oil, as Bespoke Investment Group analyst George Pearkes explains. 

"There's no quantitative work that demonstrates any significant relationship between TIPS or inflation swap prices and realized inflation," writes Pearkes. "In fact, when you regress realized forward CPI versus breakevens and the raw price of oil, it creates a much more reliable 'forecast' than breakevens alone."

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