The latest inflation data from the Bureau of Labor Statistics show the CPI unchanged in June, following a 0.3% decrease in May. For the full year, the CPI has risen just 1.7%, well below the Fed’s target of 2%. Since the beginning of June, an important indicator of the risk of Japanese-style deflation has begun to rise for the first time in two years.
Falling energy prices were the single largest cause of low inflation in June. Energy prices fell by 1.4% on the month, led by a 2.3% decline in the price of gasoline. The main factor that prevented another overall decrease in the CPI was a 2.7% increase in the price of food, driven in part by a severe drought and heat wave in U.S. farm country.
The numbers from the BLS tell us what has been happening to inflation in the recent past. To learn what market participants expect regarding the future risk of inflation or deflation, we need to turn to other sources. One such source is the Atlanta Fed’s Inflation Project, which publishes a weekly estimate of the probability of deflation over a five-year time horizon.
The deflation probability is calculated using market prices for TIPS (Treasury Inflation-Protected Securities). To protect TIPS holders from inflation, the Treasury adjusts the face value of each security upward once each six months according to changes in the CPI. For example, let’s say you buy a $1,000 TIPS today at face value. Six months from now, suppose the CPI has risen 2%. If so, the Treasury adjusts the face value of the security upward to $1,020 and pays interest on the new face value.
If there is deflation, the Treasury can adjust the face value downward. For example, if, during the second six months you hold your TIPS, the CPI falls by 1%, the face value will decrease from $1,020 back to approximately $1,010. However, there is a bonus in the adjustment formula. Although you are fully protected against the risk that the CPI will increase, you are not fully exposed to the risk that it will decrease, because the face value of your security can never drop below its $1,000 issue price.
Economists at the Atlanta Fed exploit that feature of TIPS to calculate the implied probability of deflation. They use the fact that the deflation protection in a recently issued TIPS, which will be trading at or close to face value, is greater than the deflation protection in a TIPS issued several years ago. The latter will have a face value that has been adjusted upward over time due to past inflation. As a result, in the event of deflation, it has farther to fall before it hits the floor. The math behind the computation of deflation probability, explained here, is daunting, and the people behind it admit that there are methodological limitations. Details aside, though, the concept does have the advantage of giving a number based on actual market transactions, not just a survey.
The following chart summarizes the evolution of deflation expectations over the past couple of years according to the Inflation Project. Back in 2010, when monthly headline inflation was running around zero, the probability that the April 15, 2015, CPI would be lower than the April 15, 2010, CPI peaked at over 30%. Then, as headline inflation rose in 2011, deflation risk receded. Now it is on the rise again.
In case 15% does not sound like a very large risk, notice that the chart measures the probability not just of a brief drop in the CPI, but of sustained, Japanese-style deflation. For example, if prices fell by 1% per year for the next three years, followed by two years of 1.8% inflation, still below the Fed’s target, everyone would be talking about deflation as an established fact. However, that sequence would still leave the 2017 CPI slightly higher than the 2012 CPI, so it would not meet the threshold set by the Atlanta Fed’s methodology.
Furthermore, note that deflation risk for the time horizon running from April 2012 to April 2017 is distinctly higher than the risk over the nearer 2011 to 2016 horizon. That suggests that TIPS market participants have decreasing faith in the Fed’s will or ability to hit its stated 2% inflation target. Either they think that the Fed will be too indecisive to act in time to keep inflation on target, or they think a QE3 program, if adopted, will fail to do the job.
In a speech last week, Atlanta Fed President Dennis P. Lockhart gave some of the reasons for market participants not to expect the Fed to act decisively against deflation risk anytime soon. Lockhart discusses three issues that divide the Federal Open Market Committee.
- There is considerable disagreement regarding the output gap. Some FOMC members accept the Congressional Budget Office’s view that the gap is around 5.5% and holding steady. Others think the CBO pays insufficient attention to structural changes in the economy, and believe the gap may now be close to zero.
- Another disagreement concerns risks posed by the Fed’s balance sheet, which has tripled in size since 2008. FOMC members with lingering monetarist tendencies see the huge growth of the monetary base as a harbinger of future inflation. Others, including Fed Chairman Ben Bernanke, are confident the Fed has the tools needed to reverse the growth of the balance sheet when the time comes.
- A third disagreement concerns the strength of the transmission mechanism. Those who think the transmission mechanism from monetary policy to nominal GDP is weak think QE3 or other expansionary policy would have little effect even if tried.
Lockhart himself is a middle-of-the-roader. He is satisfied with the Fed’s policy stance to date, but is ready to vote for expansionary measures if data on inflation, jobs, and GDP continue to weaken as the year goes on. He does not specifically cite his own staff’s work on deflation risk, but we can assume that the numbers cross his desk. If they continue to evolve as they have in recent weeks, perhaps they will help nudge him and his FOMC colleagues toward activism.