US economy

Fed meets as market measures point to deflation risks

Market measures of short-term inflation expectations remain at the lowest levels since the financial crisis, putting pressure on the Federal Reserve to address deflation risks at its meeting this week.

Investor expectations are reflected in prices for derivatives that can be used to hedge inflation risks. One-year inflation swaps indicate an inflation rate of minus 1 per cent, while two-year inflation swaps are pricing in an inflation rate just below zero — the lowest levels since 2008.

“Demand has just collapsed,” said Steven Blitz, chief US economist at TS Lombard. “It is going to take time for that to come back.” Mr Blitz wrote in a recent note that “deflation and very low inflation is the clear call for the next 18 months”.

The impact has yet to show up in the Fed’s favourite inflation gauge, the core personal consumption expenditures price index (core PCE) as the most recent reading covers the period before much of the US was shut down to stop the spread of coronavirus. In February the index rose 1.8 per cent year over year, up from 1.7 per cent the previous month.

Analysts also caution that market inflation expectations are particularly sensitive to changes in oil prices, which have plunged in recent weeks. But they say the severity of the economic blow from the coronavirus pandemic raises the possibility of falling prices.

“In the near-term, I worry about deflation,” said Bob Michele, chief investment officer at JPMorgan Asset Management, adding that he did not expect a “prolonged period” of price declines because he anticipated the Fed remain will accommodative for an “extended” amount of time.

Chart showing one-year US inflation swaps

Longer-term market gauges show investors do not expect the extraordinary rescue measures undertaken by the US central bank and the federal government are likely to trigger a surge in consumer prices.

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The 10-year “break-even” rate, which is derived from prices of inflation-protected government securities, is 1.16 per cent. Meanwhile, a swap rate that measures expectations of the average level of inflation over five years from now sits slightly higher at 1.9 per cent.

“We are not of the view that we will have structurally higher inflation,” said Mike Riddell, a portfolio manager at Allianz Global Investors. He described current market pricing of short-term inflation expectations as “excessive” and forecast inflation to eventually rise but fall short of the Fed’s 2 per cent target.

Ian Lyngen, the head of US rates strategy at BMO Capital Markets, said longer-dated Treasuries were benefiting from the inflation backdrop. He noted that investors were nonetheless paying up to protect against future inflation, pointing to strong demand at an auction of five-year Treasury inflation-protected securities last week.

Investors have called on the Fed to offer more guidance on the future path of its monetary policy and liquidity measures to shore up confidence, but many are sceptical the central bank will be able to achieve its inflation goals. 

“The Fed is not going to say it is out of bullets or that there is nothing they can do [about inflation],” Mr Blitz said. “But as analysts and economists, we should recognise the limits of the Fed.”

Additional reporting by Eric Platt in New York


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