Extracting economic information from asset prices is a difficult task. Yet it is likely worth the effort in the case of the collapse in the yield spread between Treasury Inflation-Protected Securities and the more quotidian nominal U.S. Treasuries.
This spread is known as the breakeven inflation rate (BEIR). It’s the inflation compensation that investors command to move from TIPS to nominal Treasuries, because TIPS’ cash flows are contractually linked to the consumer price index (CPI), a widely followed measure of U.S. inflation.
Earlier this year, the BEIR for five years starting in five years’ time declined further — it was already lower than 2008–’09 financial crisis levels (see chart 1). There are three possible explanations: Inflation expectations turned lower, investor preference shifted away from using TIPS to hedge inflation risk, or the liquidity of the TIPS market decreased.
Recent Federal Reserve working papers have suggested liquidity might be causing the decline in the BEIR. We at PIMCO disagreed, questioning in a March 14 blog post whether the Fed is missing this important market signal because of either a misunderstanding or because of a desire to convince market participants it can reach its goal. We don’t think liquidity has deteriorated in TIPS, because volumes are high by historical standards, and transaction costs have been stable.
We see three reasons why the decline was caused by a change in inflation expectations, rather than a change in investors’ preferences.
The Fed’s cumulative miss on its own target
Since January 25, 2012, the Fed has set its inflation target at 2 percent, as measured by the personal consumption expenditures index. The green line in chart 2 shows what the PCE index would look like if it were growing at the 2 percent target; the red line is the actual core PCE index. Core prices are 6 percent lower than where they would be if the Fed had reached its target. Clearly, the Fed’s recent record on meeting its inflation goal isn’t stellar. More important, low inflation can feed into low inflation expectations, which in turn feed into lower inflation.
It’s not the mode; it’s the distribution
Surveys and economists focus on the mode — that is, the event most likely to happen — but perhaps they are missing some granularity in the distribution of inflation. What is the probability of getting no inflation or 4 percent inflation? A change in the distribution of inflation is as relevant as the mode, if not more.
It may well be that investors and economists agree that 2 percent is the most likely inflation rate for the next decade, but investors care about the distribution and may assign a higher probability to deflation risks than inflation ones. Indeed, options protecting for deflation risks are 20 percent more expensive than the ones protecting for inflation risks. Lower breakeven rates may well reflect a change in the distribution of inflation tail risks.
Global disinflationary forces
Excess capacity and weak demand globally have pushed commodity prices, as well as inflation, lower in most of the developed world, including many of the U.S.’s leading trading partners. Europe and Japan are still battling deflation risks, and China’s excessively leveraged economy could be another headwind. Divergence in inflation is possible, but a stronger dollar combined with low prices abroad will translate into lower import prices in the U.S.
This disinflationary picture doesn’t mean inflation expectations are stuck in the doldrums. Like the Fed, we see the most likely outcome for U.S. inflation as a rise toward the target, thanks in large part to a tight labor market. This opinion isn’t yet a consensus view, however. We think low breakevens indicate that investors are more concerned with the Fed undershooting, rather than overshooting, its target. A good strategy to reanchor inflation expectations would be to let inflation run slightly above the Fed target to compensate for the years spent lingering below that threshold.
The Fed seems more comfortable considering truly unconventional — and, in our opinion, counterproductive — measures such as negative interest rates to boost inflation expectations, rather than the far simpler approach of either stating that it would allow inflation to run above the 2 percent target or raising the 2 percent target itself, as suggested recently by former IMF chief economist Olivier Blanchard at our Secular Forum and by former Treasury secretary Larry Summers.
Fed officials maintain that a 2 percent target is a reasonable one. Yet there are plenty of market participants who think policymakers may fall short.
Jeremie Banet is an executive vice president and a portfolio manager on the real return team at PIMCO's headquarters in Newport Beach, California.
