Will the recent decline in inflation impact the path of US monetary policy rates in the near term? Inflation has received increased focus this year as the US Federal Reserve (Fed) prepares for “lift-off”, with one leg of their dual mandate below target. Inflation data has drifted lower, potentially impacting long-term price stability. This has occurred despite persistent strength in labor markets leading some to speculate that global deflationary forces have migrated to US soil.
The Fed has repeatedly dismissed the recent decline in realized inflation as transitory and largely due to falling energy prices. Headline inflation, which is directly impacted by a decline in gasoline prices, has historically experienced significant variability. By contrast, core measures of inflation exclude volatile food and energy items, resulting in a more stable gauge of consumer prices. The pass-through of energy shocks from headline to core remains to be seen, but historically has been limited. This implies that recent disinflationary concerns are misguided and unlikely to impact inflation expectations.
Accurately quantifying inflation expectations is challenging, and recent measures have been mixed. The University of Michigan one-year inflation survey has been trending higher since reaching a 12-month nadir in January. Meanwhile, the Federal Reserve Bank of Philadelphia Survey of Professional Forecasters (SFP) is predicting that core CPI will decline modestly throughout 2015, before trending back toward 2% in the following year. This view is supportive of the Fed’s transitory argument and seems credible as survey-based measures have historically been reasonable predictors of inflation.
Market-based measures of inflation provide an alternative perspective of future inflation. Some view market measures as more reliable given that they represent a level of conviction backed by investor risk capital. Market-implied inflation, derived from US Treasury inflation-protected securities (TIPS) and inflation swaps, have declined sharply, suggesting that long-term inflation expectations have fallen well below 2%. The trend closely follows the fall in crude oil prices since mid-year 2014.
Both survey and market measures of inflation expectations have their challenges. While inflation surveys have exhibited statistical significance in predicting long-term inflation trends, the relevance of survey data has been more recently called into question given the awkward stability of the series throughout the great recession. Market-based measures, on the other hand, are potentially being distorted by supply/demand technicals. Some have argued that an increase in global demand for nominal US Treasuries has depressed intermediate yields and compressed the spread between nominal and real yields, known to inflation traders as the breakeven inflation (BEI) rate. Some of the movement in BEI rates can be explained by the decline in the term premium of inflation, which has fallen as inflation risk has become increasingly skewed to the downside. In any case, market-based measures may be more accurate in capturing the short-term directional trend of inflation rather than the medium- to long-term evolution.
A decline in US inflationary pressures may prove to be less significant if it is driven by a combination of declining energy prices and a strengthening US dollar. A strong US dollar has historically coincided with significant growth and employment gains, which establish a firm base for consumption as purchasing power increases. Additionally, lower fuel prices should support consumption and bolster the economic recovery. We recognize that there are also negative implications. Energy producers have reduced capacity and furloughed thousands of workers in response to lower crude oil prices. US exports have become more expensive as the US dollar has appreciated and failed to keep pace with rising imports. However, the positives associated with “good” inflation should outweigh the negatives.
During the third week of March, the Federal Open Market Committee (FOMC) meetings dominated the headlines. As expected, the Fed removed the key word “patience” from the statement, replacing it with less specific forward guidance. In addition, Fed officials downgraded their forecast for the US economy by revising growth, inflation and interest rate projections lower. During the press conference on 19/03/15, Chair Janet Yellen acknowledged that inflation declined below target as a result of lower energy prices and declining import prices, though continued to characterize conditions as transitory. Only time will tell if the US can “buck this global disinflationary trend”...