The market doesn't believe the Fed can deliver +2% inflation
Former Minneapolis Fed super-dove Narayana Kocherlakota is bloging about monetary policy now. His latest post focuses on the decline in market-implied inflation.
He focuses on breakevens (which are nominal yields minus TIPS) and notes the decline since mid-2015. He also explains the five-year five-year forward breakeven:
The five-year five-year forward breakeven is defined to be the difference between the 10-year breakeven [currently 1.39%] and the five-year breakeven [currently 1.11%]. Intuitively, this difference in yields is shaped by beliefs about inflation over a five year horizon that starts five years from now. In particular, there is no reason for beliefs about inflation over, say, the next couple years to affect the five-year five-year forward breakeven.
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.
Here is the 10-year breakeven, which is now implying 1.38% inflation over 10 years, down from nearly 1.60% at the start of the year.
Kocherlakota says the Fed should reverse course.
"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," he writes.
There's nothing new from Kocherlakota here since he left the Fed in December but it's good to see him speaking more openly.
