By Mike Dolan
LONDON (Reuters) – At a critical stage in charting the economic voyage back to normality, the inflation compass may be going haywire.
Global markets now hinge on whether the post-pandemic economic rebound and massive financial supports lift inflation sustainably over time, or maybe send price rises spiraling.
And one of the few ways to assess that is to look at key market and survey based expectations.
These probably define your view of the speed with which central banks normalize rock-bottom borrowing rates; when or if stock and bond markets that rely on that support correct; or even the path of the world’s main reserve currency.
But there are good reasons to suspect signals from the U.S. Treasury’s inflation-protected securities (TIPS), widely used by policymakers and asset managers, are distorted and too high even as they draw some of the biggest investment inflows in 6 months.
So-called ‘breakevens’ that reflect what investors see as likely average inflation rates over 5, 10 and 30 years are simply the gap between nominal bond yields and those on inflation-hedged ones.
In theory, fear of rising inflation increases demand for inflation-protected bonds and drives down the TIPS yield – the ‘real’ or inflation-adjusted yield – relative to nominal yields and to the point where the market clears at its view of future inflation.
Along with household surveys and various swap markets, central banks then see how credible their inflation goals are.
Right now, they are critical to determining whether wild monthly swings in prices around lockdowns and re-openings are anything other than noise from base effects and bottlenecks.
And yet there’s some suspicion that limited supply of these bonds and the fact the Federal Reserve is buying up a growing proportion as part of its monetary policy is distorting their signal and overstating rather than underestimating market fears.
OUTSIZE FOOTPRINT
JPMorgan’s bonds team point out the Fed’s own “footprint” in TIPS has been “outsized” mainly because auction sizes have increased by less than nominal bonds. Fed purchases have more than fully absorbed net TIPS issuance for the past year and will likely continue do so for the rest of 2021 as well, it said.
The share of the TIPS market held by the Fed has risen to 24% from less than 10% prior to the pandemic and primary dealer positions have fallen even more sharply than in regular bonds.
At the very least, this would prevent the Fed from buying more TIPS if it wanted to readjust its $120 billion a month commitment from mortgage bonds to Treasury bonds, JPM said.
“Increasing the pace of monthly purchases in the product could create undue distortions which would make it more difficult to discern pricing signals from TIPS,” it said.
Some think that’s already happening. John Canavan at Oxford Economics thinks the distortion is already “exaggerating” breakeven inflation rates.
So, are 2.65% and 2.46% breakevens for 5- and 10-year TIPS respectively really overcooked?
There’s certainly no shortage of private demand for these securities. Bank of America’s latest weekly fund flows monitor show the biggest inflows to TIPS funds in 24 weeks.
But this demand on top of Fed buying has sunk real yields deeply sub-zero, to a record -1.9% on five-year TIPS.
Inflation-linked swaps markets, such as the 5-year/5-year forwards, suggest lower rates of 2.40%.
Is the Fed distorting its own compass?
Perhaps knowledge of the skew is one reason Fed officials appear so comfortable that expectations remain ‘well anchored’, while accepting rates above its 2% core inflation target for a period is an integral part of its new strategy to average that target over time.
Friday’s release of the Fed’s favored core PCE inflation measure is expected to show April running at 2.9% – still widely affected by pandemic bottlenecks.
But, as HSBC point out, core PCE would have to average 3% for 12 months to pull a moving average of the last three years to 2.0% and get even close to satisfying the Fed’s new regime.
Surveys of expectations offer no crystal ball either.
University of Michigan’s household surveys show 1-year and 5-year expectations are at 10-year highs above 4% and 3% respectively. But these have consistently overstated actual core PCE outcomes by a large margin for most of the past 25 years.
Private companies – who are price takers, setters and wage bargainers – don’t appear to be much better.
A recent paper by economists Bernardo Candia and Yuriy Gorodnichenko at the University of California, Berkeley and Olivier Coibion at the University of Texas examined their 3-year old quarterly survey of U.S. firms for clues.
But they found it largely mirrored household polls in persistently over-estimating inflation, with huge variations and disagreements and frequent big revisions of what firms assumed.
Remarkably, less than a fifth of chief executives in the survey even knew what the Fed’s inflation target was.
The economists conclude that firms’ inflation expectations “appear far from anchored”. But they reckon one reason for the “inattention” to monetary goals reflects just how long inflation has not been a problem.
(by Mike Dolan, Twitter: @reutersMikeD. Charts by Stephen Culp, JPMorgan. Additional reporting by Karen Pierog. Editing by Alexander Smith)
