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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).
Its 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 200809 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
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 dont think
liquidity has deteriorated in TIPS, because volumes are high by
historical standards, and transaction costs have been
We see three reasons why the decline was caused by a change
in inflation expectations, rather than a change in
The Feds 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
Feds recent record on meeting its inflation goal
isnt stellar. More important, low inflation can feed into
low inflation expectations, which in turn feed into lower
Its not the mode; its 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
Chinas 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 doesnt 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 isnt 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
Treasury secretary Larry Summers.