No Deflation Scare at Fed Despite Commodity Price Fall

Monday, 22 Apr 2013 03:58 PM

 

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Falling commodity prices and softer growth have fanned concern U.S. inflation could slow further, killing chances of the Federal Reserve tapering its $85 billion a month of bond purchases any time soon. But officials do not yet share market worries over deflation.

Several Fed policymakers last week cited a readiness to increase the pace of bond buying to defend their goal for 2 percent inflation, including arch-hawk Jeffrey Lacker, president of the Richmond Fed. They just don't expect inflation to continue to fall.

U.S. consumer prices, as measured by the Fed's preferred gauge, were up only 1.3 percent over the 12 months through February, well below the central bank's 2 percent target.

"If I thought it were going to persist this low or even fall further, I, of course, would be giving serious thought to providing monetary stimulus to get the inflation rate back to 2 (percent)," Lacker said on Thursday.

"I don't see a material risk now of the rate of inflation falling substantially further."

However, Fed officials are clearly signaling the decline in inflation has gotten their attention, even if it is not yet flagging a re-run of the much clearer deflation scare that pushed the Fed to deliver a second round of so-called quantitative easing, or QE2, back in 2010.

Policy centrist James Bullard, head of the St. Louis Fed and a voter this year, said on Wednesday he would be willing to increase the pace of purchases if inflation continued to fall. Minneapolis Fed chief Narayana Kocherlakota also made a similar point last week.

Inflation has been helped lower by sliding commodity markets, led by gold, which has nosedived in recent weeks. Oil prices are off 16 percent from the year's high for Brent crude, while broader commodity price indexes have also slipped over 7 percent this month, according to the Standard and Poor's Goldman Sachs Commodity Index.

GOLD GLOOM

The decline, particularly of gold, has spurred market speculation of a looming deflationary threat amid skepticism that major central banks will be able to revive global growth.

Fed officials are not terribly worried by the swing in the gold price, and point out it responds to many different themes in financial markets, including price pressures.

But they readily agree that inflation is also not heading higher, a point Fed Chairman Ben Bernanke repeated to colleagues at the G-20 meeting in Washington late last week

That view will aid doves at the Fed's upcoming meeting on April 30-May 1 in their argument that it needs to keep buying bonds at an $85 billion monthly pace until well into the fall.

Minutes of the meeting last month revealed many policymakers thought stronger growth might warrant buying being reduced over coming months. But a weak March jobs report and other signs of a so-called "spring swoon" in U.S. growth have pushed back expectations of imminent tapering.

However, Fed officials say lower commodity prices should be treated in the same way by policymakers as rising prices in the past, when the Fed showed patience in the face of spikes in energy and food costs that temporarily buoyed inflation, at least until they translate much clearer warnings of deflation.

"I don't think anyone is forecasting this thing going down much further," said Chris Waller, head of research at the St. Louis Fed. "But our target is 2 percent, not 1.3 percent ... and in that sense we'd like to get inflation up to target."

Yet, with expectations for future inflation still hovering comfortably above 2 percent, the Fed would need to see clear downward pressure from the real economy pushing in the other direction to grow seriously alarmed.

"If we kept seeing payroll numbers of 88,000 for the next 4 or 5 months, then I think we would have concerns about both inflation and the economy heading on the downside," said Waller.

March payrolls showed a disappointing 88,000 jobs added in the month, breaking a run of stronger-than-expected jobs numbers and putting markets on edge the recovery may stumble again, as it has in each of the last 3 years.

TIPS SPREAD NARROWS

One way the Fed keeps tabs on inflation expectations is via the break-even spread between yields on Treasury Inflation Protected Securities, or TIPS, and normal treasury bonds.

TIPS prices fell sharply on Thursday after a disappointing auction that reflected diminished concerns over inflation, with the 10-year TIPS break-even rate suffering its sharpest one-day decline in seven months.

But even after ending 12 basis points narrower on the week, the 10-year TIPS break-even spread still closed at 2.32 percent.

Back in 2010, when the Fed's preferred inflation gauge averaged 1 percent in the third quarter and 0.8 percent in the fourth quarter, the break-even spread on the 10-year TIPS touched a low of 1.56 percent on the eve of the annual central banking symposium at Jackson Hole, Wyoming, in late August.

Bernanke hinted at QE2 during the conference, and within a few weeks the break-even spread was back above 2 percent.

The Federal Reserve Bank of Atlanta runs a deflation probability calculator on its website. This currently shows the probability of a lasting deflation is zero, based on readings from the TIPS market.

TIPS are not a foolproof way to measure future inflation expectations. But alternative sources of evidence give similar indications.

"We have a lot of reason to believe, from a variety of other indicators, that the probability of a deflation is very low," said Mike Bryan, a senior economist at the Atlanta Fed. "When we talk to businesses, the outlook, positive or negative for inflation, seems pretty sanguine."

© 2014 Thomson/Reuters. All rights reserved.

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