Bad News: Even Long-Term Expectations of Inflation Are Falling

Charles Evans, president of the Federal Reserve Bank of Chicago Photograph by Patrick Fallon/Bloomberg

Very low inflation goes hand in hand with weak economic growth, so it’s worrisome that bond investors are expecting inflation to be low even five to 10 years from now. A measure of expected future inflation called the “5-year forward 5-year inflation breakeven rate” has dropped sharply in the past few weeks, a point noted in a speech today by Charles Evans, the dovish president of the Federal Reserve Bank of Chicago.

“There is a risk, too, that inflation expectations could themselves fal—indeed, I would note that longer-dated TIPS break-evens have recently dropped to the lower end of their expectations range,” Evans said, according to his prepared remarks.

Michael Feroli, chief U.S. economist of JPMorgan Chase, says in a client note today that Evans was probably referring to the 5-year forward 5-year inflation breakeven rate, which is shown in this chart.

The measure takes a little explaining. The idea is to use market data to figure out what investors expect inflation to be like over the five years that begin five years from now—in this case, from 2019 to 2024. It’s based on the differences in yields in the forward contracts for ordinary Treasuries and Treasury Inflation-Protected Securities, or TIPS.

The chart shows expected inflation above the Fed’s long-term target of 2 percent as measured by the Consumer Price Index, but Feroli says it would probably be below 2 percent if it were calculated using the Fed’s preferred measure of inflation, which is based on personal consumption expenditures in the government’s calculation of gross domestic product. In other words, the market expects inflation to be below the Fed’s target even five to 10 years from now.

Evans is more of a dove than the average member of the rate-setting Federal Open Market Committee, which means he’s more worried about slow growth, high unemployment, and inflation that is chronically below the 2 percent rate that the Fed itself is committed to achieving. Minutes of the FOMC’s September meeting, released today, show that Evans is in a minority in worrying about falling expectations of inflation. According to the minutes, “Inflation was running below the Committee’s longer-run objective, but longer-term inflation expectations were stable. Participants anticipated that inflation would move toward the Committee’s 2 percent goal in coming years, with several expressing concern that inflation might persist below the Committee’s objective for quite some time.”

Feroli notes that the expectations measure can bounce around for technical reasons, so it’s not a highly reliable guide to market sentiments. But he adds, “the longer these measures remain subdued, the more we can expect Fed speakers to make mention of the development.”

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