A ‘lopsided’ Fed

Justin Wolfers has an interesting article on a nascent Prediction Market: “Concerns About Deflation Show Up in an Obscure Derivatives Market”:

Something unusual is happening to prices right now: They are falling.

The recent sharp decline in gas prices is part of the story, but there is now growing fear that the Federal Reserve will undershoot its own 2 percent inflation target, hindering the economic recovery. There’s also a small but worrying risk that the economy could enter a deflationary rut.

At issue are inflation expectations. Economists believe expectations are critical because they shape the decisions individual shopkeepers make when deciding whether and by how much to raise their prices. Beliefs about inflation create a self-fulfilling prophecy in which today’s expected inflation becomes tomorrow’s actual inflation. The trick to managing inflation then, is to manage inflation expectations. In practice, though, it is very hard to observe what people expect inflation to be.

That’s why it’s worth paying close attention to the disturbing portents from a relatively young and obscure derivatives market that provides new perspectives on inflation expectations — tracking not only the likely level of inflation, but also the risks that inflation might be too high, too low or just right. In this market, derivatives called inflation caps and inflation floors are, effectively, bets on the trajectory of prices over the next few years.

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For several years now, these markets — as well as related inflation-indexed bonds and inflation swaps — have been a source of comfort for policy makers, as they reported that inflation expectations were roughly consistent with the Fed’s inflation target. But over the last half-year, the markets have sounded a largely unheralded alert siren, reporting that expected inflation has fallen sharply. Inflation is now expected to run half a point or more below target for many years.

To some extent, this decline in inflation expectations reflects a vote of confidence in the Fed, as earlier fears of high inflation have come to be seen as an increasingly distant possibility. But it also reflects fears of Fed timidity, as the risk of prolonged deflation remains high.

By this measure, the Fed has been halfway successful at establishing its credibility, successfully bolstering its inflation-fighting bona fides, but failing to instill sufficient confidence that it stands ready to fight the drag of very low inflation or outright deflation.

As I argued here, the Fed is trying to compensate for its failure with a “bad attitude”, considering the mostly useless NAIRU concept as providing the “blueprint” for its interest rate decisions.

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