‘Staggering’ collapse in inflation expectations may force Fed’s hand

Market measures of inflation expectations have collapsed in the US, cementing a sense among analysts that the Federal Reserve will be forced to follow Europe and Japan by pushing interest rates towards zero.

On Wednesday a swap rate that measures expectations of the average level of inflation over five years, five years from now, sank to 1.16 per cent, its lowest level since the data series began in 1999, before edging higher. Meanwhile, the 10-year “break-even” inflation rate, which is derived from prices of inflation-protected government securities, dropped to 0.92 per cent — the lowest since March 2008.

The gauges are used by policymakers to judge whether markets think the central bank can keep the inflation rate near to its target of 2 per cent over the longer term. In both cases, the rates were about 1.8 per cent at the turn of the year.

“It is just staggering,” said Brian Levitt, global market strategist at OppenheimerFunds. “What you have right now is investors pricing in very little growth or inflation over long periods of time.”

Analysts noted that inflation expectations tended to be particularly sensitive to changes in oil prices, which had plummeted in the wake of the price war between Saudi Arabia and Russia. But even without that, they said, the pressure would be mounting on Fed chair Jay Powell to take more action to counter the threat of the coronavirus outbreak, and the potential economic damage that accompanied it.

Futures prices compiled by Bloomberg indicate that the central bank will cut its main policy rate by three-quarters of a percentage point at its scheduled policy meeting next week, bringing it to a range between 0.25 per cent and 0.5 per cent. JPMorgan’s chief US economist Michael Feroli on Tuesday said he expected the Fed to go further and cut to zero, bringing it closer to the negative-rate policy pursued by the Bank of Japan and the European Central Bank.

Last week, in its first emergency cut since the peak of the global financial crisis, the Fed slashed its rate by half a percentage point.

“The collapse in inflation expectations gives the Fed a greenlight to be really, really aggressive,” said Ashok Bhatia, deputy chief investment officer for fixed income at Neuberger Berman. “There is now the potential for a very significant recession.”

The most recent reading of the consumer price index indicated that core prices, which exclude volatile items such as food and petrol, climbed 2.4 per cent on a year-on-year basis in February.

The Fed tends to focus on another inflation measure, the personal consumption expenditures price index, which stood at 1.7 per cent in January, up from 1.5 per cent a month earlier. But Ward McCarthy, chief financial economist at Jefferies, said that all inflation data was bound to be “abysmal” in coming months because of the fast-spreading disease and the depressed oil market.

For Mr Levitt of OppenheimerFunds, the sharp fall in inflation expectations is an “overreaction”. Growth would eventually pick up, he said, as the Fed eased financial conditions and the government did its best to stimulate activity.

“The US is going to grow,” he said. “We just have to get through this period.”

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