Dealers Counter Fed on Falling Inflation Expectations

The banks and brokerage firms that trade directly with the Federal Reserve disagree with central bank officials on why market-based measures of inflation expectations have been declining, according to the results of a survey of those firms published today.

The majority of the decline in so-called break-even inflation rates in September and the first half of October was driven by “the decline in crude oil prices, increased concerns regarding global growth and inflation, and expectations for the Federal Reserve to begin reducing monetary policy accommodation,” said the 22 primary dealers surveyed by the New York Fed ahead of the Federal Open Market Committee’s Oct. 28-29 meeting in Washington.

The survey was distributed on Oct. 16 and answers were collected by Oct. 20.

A measure of average expected annual inflation over the five-year period beginning five years from now fell to 2.37 percent on Oct. 15 from 2.53 percent on Sept. 2.

Dealers attributed less than half of the drop to a decline in the so-called inflation risk premium, or the amount investors are willing to pay to protect against an unexpected surge in inflation.

Dudley’s Explanation

The survey results run counter to the narrative advanced by New York Fed President William C. Dudley, who said “much of this decline” in break-even inflation rates “reflects a fall in the inflation risk premium,” citing research conducted by his staff in a Nov. 13 speech in Abu Dhabi.

Fed officials have used this explanation to downplay market-based measures of inflation expectations, instead pointing to consumer surveys of expectations as evidence that price increases, which have lagged behind the central bank’s 2 percent target for more than two years, will start to move back up toward their goal.

Those surveys are also starting to show consumers expect price increases will decelerate.

Consumers’ outlook for average annual inflation five to 10 years from now slid to 2.6 percent this month from 2.8 percent in October, marking the lowest reading since March 2009, according to preliminary results of a Thomson Reuters/University of Michigan survey released Nov. 14.

At the FOMC’s October meeting, “many participants observed that the committee should remain attentive to evidence of a possible downward shift in longer-term inflation expectations,” according to minutes published yesterday.

“One participant noted that even if the declines reflected lower inflation risk premiums and not a reduction in expected inflation, policy makers might still want to take them into account because such a change could reflect increased concerns on the part of investors about adverse outcomes in which low inflation was accompanied by weak economic activity,” the minutes showed.

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