More on the "risk" of inflation. This is from Narayana Kocherlakota:
Information in Inflation Breakevens about Fed Credibility: The Federal Open Market Committee has been gradually tightening monetary policy since mid-2013. Concurrent with the Fed’s actions, five year-five year forward inflation breakevens have declined by almost a full percentage point since mid-2014. I’ve been concerned about this decline for some time (as an FOMC member, I dissented from Committee actions in October and December 2014 exactly because of this concern). In this post, I explain why I see a decline in inflation breakevens as being a very worrisome signal about the FOMC”s credibility (which I define to be investor/public confidence in the Fed’s ability and/or willingness to achieve its mandated objectives over an extended period of time).
First, terminology. ...
Conceptually, the five-year five-year forward breakeven can be thought of as the sum of two components:
1. investors’ best forecast about what inflation will average 5 to 10 years from now
2. the inflation risk premium over a horizon five to ten years from now - that is, the extra yield over that horizon that investors demand for bearing the inflation risk embedded in standard Treasuries.
(There’s also a liquidity premium component, but movements in this component have not been all that important in the past two years.)
There is often a lot of discussion about how to divide a given change in breakevens in these two components. My own assessment is that both components have declined. But my main point will be a decline in either component is a troubling signal about FOMC credibility.
It is well-understood why a decline in the first component should be seen as problematic for FOMC credibility. The FOMC has pledged to deliver 2% inflation over the long run. If investors see this pledge as credible, their best forecast of inflation over five to ten year horizon should also be 2%. A decline in the first component of breakevens signals a decline in this form of credibility.
Let me turn then to the inflation risk premium (which is generally thought to move around a lot more than inflation forecasts). A decline in the inflation risk premium means that investors are demanding less compensation (in terms of yield) for bearing inflation risk. In other words, they increasingly see standard Treasuries as being a better hedge against macroeconomic risks than TIPs.
But Treasuries are only a better hedge than TIPs against macroeconomic risk if inflation turns out to be low when economic activity turns out to be low. This observation is why a decline in the inflation risk premium has information about FOMC credibility. The decline reflects investors’ assigning increasing probability to a scenario in which inflation is low over an extended period at the same time that employment is low - that is, increasing probability to a scenario in which both employment and prices are too low relative to the FOMC’s goals.
Should we see such a change in investor beliefs since mid-2014 as being “crazy” or “irrational”? The FOMC is continuing to tighten monetary policy in the face of marked disinflationary pressures, including those from commodity price declines. Through these actions, the Committee is communicating an aversion to the use of its primary monetary policy tools: extraordinarily low interest rates and large assetholdings. Isn’t it natural, given this communication, that investors would increasingly put weight on the possibility of an extended period in which prices and employment are too low relative to the FOMC’s goals?
To sum up: we’ve seen a marked decline in the five year-five year forward inflation breakevens since mid-2014. This decline is likely attributable to a simultaneous fall in investors’ forecasts of future inflation and to a fall in the inflation risk premium. My main point is that both of these changes suggest that there has been a decline in the FOMC’s credibility.
To be clear: as I well know, in the world of policymaking, no signal comes without noise. But the risks for monetary policymakers associated with a slippage in the inflation anchor are considerable. Given these risks, I do believe that it would be wise for the Committee to be responsive to the ongoing decline in inflation breakevens by reversing course on its current tightening path.