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FOMC members fret over deflation risks – Sober Look

This is a syndicated repost courtesy of Sober Look. To view original, click here. Reposted with permission.

Some FOMC members continue to focus on the historically low inflation levels in the US (see post). They are worried about repeating the Japan experience of being stuck in a deflationary regime for years. They want to see some inflation return before changing policy.

Chicago Fed President Charles Evans: – “For me, to start the wind-down, it will be best to have confidence that the incoming data show that economic growth gained traction during the third quarter of this year and that the transitory factors that we think have held down inflation really do turn out to be transitory.”

But it’s not just the current level of inflation that the Fed is monitoring. As important (if not more) for policy decisions are inflation expectations – the markets’ consensus of future inflation. The Cleveland Fed has developed a methodology to track expectations of future inflation (described here). It’s basically the breakeven (market implied) inflation minus what they refer to as “risk premium” – a historical volatility based measure (“GARCH processes” for those who are interested). And the last time this number was published, inflation expectations picked up – which must have made some of the FOMC members quite happy. The US is not becoming another Japan …

Source: Federal Reserve Bank of Cleveland

But since this inflation expectation result was last published in mid August, the situation has changed. While the “risk premium” adjustment in the calculation is a bit “over-engineered”, the measure is relatively constant.  This makes it possible to estimate intramonth moves in the Fed’s inflation expectations using simple breakeven rates based on TIPS (inflation protected treasuries). And the breakeven rates have been declining lately.

Source: Ycharts

This may make some of these FOMC members jittery again as the “Japan fears” return. What may add to their concerns is that the Eurozone is now also showing potential deflationary risks. The EMU inflation rate has been surprisingly low.

The next inflation expectation numbers come out the same day as the CPI – September 17th (8:30 AM). On that same day the FOMC begins its meeting. Will the “Japan fears” dominate the debate? The breakeven trajectory in the next week should tell us.

 

SoberLook.com

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