Dudley: Market Overstates Drop in Inflation Expectations

Federal Reserve Bank of New York President William C. Dudley dismissed the drop in a market-based measure of inflation expectations and expressed optimism that a stronger economy would allow tightening to start in 2015.

“Several of the various ‘headwinds’ that have impeded U.S. economic activity in recent years have subsided,” allowing improving fundamentals to “exert themselves more forcefully,” Dudley said today in a speech at the Central Bank of the United Arab Emirates in Abu Dhabi. “Although patience is appropriate, if all goes well, I anticipate that we will begin to raise short-term rates sometime next year.”

Most Fed policy makers expect the central bank to raise interest rates for the first time since 2006 at some stage next year, according to a quarterly survey of their forecasts released in September. The Fed has held rates near zero since December 2008.

The U.S. central bank last month ended a two-year campaign of asset purchases and retained a commitment to keep borrowing costs low for a “considerable time” to achieve its twin goals of full employment and 2 percent inflation. The Fed’s preferred gauge of price pressures, the personal consumption expenditures index, rose 1.4 percent in September from a year earlier.

The New York Fed chief, who serves as vice chairman of the policy-setting Federal Open Market Committee, said he puts more weight on survey-based measures of inflation expectations, which have remained stable, than market-based ones.

New York Fed research suggests that a drop in the price investors are willing to pay for protection against higher inflation is the cause of much of the recent decline in a bond-market measure of inflation expectations that’s derived from Treasury Inflation Protected Securities, or TIPS, Dudley said.

One such indicator, which measures average expected annual inflation over the five-year period beginning five years from now, has fallen to 2.18 percent from 2.69 percent on Dec. 31.

“Adjusting for the fall in the inflation risk premium, inflation expectations appear to have declined much less than implied by TIPS inflation breakeven measures,” Dudley said.

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