We’ve been hearing a lot more noise about the risk of deflation lately. Oil price declines over the past 18 months have dragged headline inflation rates down and this has coincided with a sharp decline in market-implied inflation expectations. St Louis Fed President James Bullard recently cited this as an argument against raising rates.
The chart below seems to indicate declining expectations clearly. It shows the oil price alongside the inflation rate implied by the difference between inflation-linked and non-inflation-linked Treasury yields.
Is this actually what’s going on though and is it justifiable? A correlation between inflation expectations and energy prices could be theoretically defensible. Energy is an input to production and can impact wages through indexation. If we look at the data though, energy prices don’t affect core underlying inflation like they once did. In fact, since 2010 there has been a flat to modestly negative relationship in the US.
Since the 1980s, increased competition from deregulation and globalisation, better anchored inflation expectations and the reduced energy intensiveness of the US economy have contributed to the fading relationship between energy prices and core inflation.
It’s therefore not clear to us that oil price moves in themselves should be impacting long-run inflation expectations in the way that some are suggesting.
In fact, measures of market-implied inflation expectations can be highly misleading. More than just expectations, they reflect investors’ willingness to protect against inflation and also the specific features of the different assets involved. Treasury Inflation Protected Securities are much less liquid than nominal treasuries for example, so a time-varying liquidity premium also affects breakevens.
Recent research by the Atlanta Fed attempts to account for this and to back out the actual inflation expectations implied by market pricing. They conclude that expectations have been fairly stable in reality, rather than collapsing as some have suggested. In fact it’s the liquidity premium that has largely driven the shift in breakeven inflation rates. This feels intuitive given the recent market turmoil, with investors flocking to “safe” liquid assets, as also noted by Macro Man.
Yields on US treasuries have declined markedly relative to the start of the year. If inflation expectations haven’t materially shifted, anybody attempting to rationalise this bond market pricing will have to begin their search elsewhere.