LONDON (Reuters) - Few doubt the willingness of central banks to tolerate periods of above-target inflation in future, as per the U.S. Federal Reserve’s new strategy of averaging its inflation goal over time -- but markets are questioning if they can even get there.
As investors take fright at fresh restrictions to halt another wave of COVID-19 infections, the prospect of 2%-plus inflation in any of the major economies seems remote -- let alone a long period above that target during which central banks will turn a blind eye.
Likely delays to fresh U.S. fiscal support until after November’s elections, due to persistent political wrangling, further cloud the picture.
This week’s simultaneous slide in the traditional inflation hedge of gold alongside equities, and the still-shy inflation-expectations embedded in bond markets, underline market scepticism.
Even though massive central bank and government stimulus to offset pandemic lockdowns has seen inflation expectations rebound, 10-year assumptions from inflation-protected U.S. Treasury securities and related swap markets still point to long-term outcomes of between 30 and 50 basis points below 2%.
The European Central Bank is expected to follow the Fed strategy at some point, but the picture is even bleaker there, with the equivalent inflation swap market as low as 1.2% -- almost half the ECB’s target.
Although monthly U.S. consumer surveys conducted by the University of Michigan consistently point to above-target inflation expectations over one and five-year horizons, these have not altered materially since the pandemic, let alone since the announcement of the Fed’s new strategy. And even these forecasts see inflation falling over the years ahead.
So can the Fed’s new average inflation target -- where it will allow annual price gains to move above 2% for a period without mechanically tightening monetary policy -- shift the dial on economy-wide expectations at all?
There’s already some evidence that the public barely understands this new signalling, suggesting the Fed’s message may struggle to gain traction among businesses and households -- undermining a key premise of the whole idea.
A study released this week by Cleveland Fed economists Edward Knotek and Raphael Schoenie, together with Olivier Coibion from the University of Texas and Yuriy Gorodnichenko at the University of California, concluded the Fed’s message is already falling on deaf ears.
Using a daily survey of up to 1,500 households from the day before the new Fed strategy was flagged on Aug. 27, the study showed only a small uptick in those claiming to have heard the news at all. And even those who heard the news didn’t seem to understand it, the researchers claimed.
“Despite extensive coverage in the news media, (Fed chairman Jerome) Powell’s speech apparently did not reach or register with the vast majority of the population,” the study said, adding those claiming to even heard any news about monetary policy around the announcement rose to just 33% from 24%.
“We find no evidence that being exposed to news about monetary policy or the Fed after Powell’s speech changed households’ perceptions of what the Federal Reserve will do nor did it affect their broader economic outlook.”
So is this idea of forcing inflation higher by muddying the target just wishful thinking for a central bank that’s undershot that goal for most of the past decade amid slow wage growth, unfavourable demographics, changing work patterns and digitisation?
The policy signal is certainly powerful if it means zero policy rates and ultra-loose credit for years to come. Stock markets that have roared back to recapture pre-pandemic peaks clearly understand that and long-term bond yields have been floored for decades out through the maturity spectrum.
But that’s not the same as being successful at actually getting inflation higher -- hence the hesitation in markets in assuming the Fed will get its way any time soon despite believing the commitment to keep rates down. The likelihood is that the pandemic will have to end to get a clearer picture, further government stimulus will have to complement central bank largesse, and delays in either will stifle the monetary signal.
Like many investors, strategists at giant asset manager BlackRock are convinced markets are still underpricing the inflation trajectory from here and the Fed’s view will prevail.
They see U.S. inflation of 2.5%-3.0% in the five years after 2025 -- a full point above where implied inflation is now priced by markets -- as shifting central bank strategies combine with changes to firms’ supply chains, more price-confident digital business and greater fiscal and monetary policy interaction.
“Once higher inflation appears, it’s likely too late for investors to react,” BlackRock told clients on Tuesday.
The author is editor-at-large for finance and markets at Reuters News. Any views expressed here are his own.
by Mike Dolan, Twitter: @reutersMikeD. Chart by Ritvik Carvalho; Editing by Catherine Evans
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