Whether you look at search patterns at google trends or mention of the "d" word in newspapers, with the latest release of the US CPI, suddenly deflation is at the headlines (literally, just look at the front pages of today's WSJ and FT). I would like to offer my two cents on two important questions: How likely is deflation and what would be the Fed's response? Today, I start with using bond yields to argue for deflation.
Before I go on, however, I should note that I am struck by the sudden shift in sentiment from inflation to deflation in the span of a mere couple of months. My awe comes not only from the shift but also the media jumping like hungry wolves on the latest US CPI data. In fact, the signals were there, and I know at least one blogger who has been calling for deflation since spring. Well, lesson learnt: It seems that the media is a lagging indicator....
Coming to the first question, the easiest way to search for deflation is to look at what markets are reflecting. A Bloomberg chart that has been circulating around the web a lot during the last couple of days compares yields between bonds that provide protection against inflation and those that don't to show that most all major economies are heading towards deflation. For the US, the five-year break-even rate suggests that investors are expecting annualized inflation to be -0.70% over the next five years.
However, there are a number of issues with using such yield differentials to measure expected inflation. For starters, there are issues about liquidity: Not only you are comparing apples and oranges (assets with different liquidity), because of structural changes in the bond market, you might be looking at Florida oranges while in fact you are chewing on the local Finike variety.
Moreover, if you control for liquidity, if people are risk-averse, the yield differential would include an inflation risk premium, giving an upward bias to inflation expectations derived from yield curve differences. I guess you could estimate this risk premium (and then scrap it to get at true inflation expectations) using volatility implied in options prices. But I am not sure if there are options on inflation...
The take from all this is that I would not put my money on deflation just based on bond yields. But there are other signs pointing towards deflation, as I will argue on my next entry on this topic...
Before I go on, however, I should note that I am struck by the sudden shift in sentiment from inflation to deflation in the span of a mere couple of months. My awe comes not only from the shift but also the media jumping like hungry wolves on the latest US CPI data. In fact, the signals were there, and I know at least one blogger who has been calling for deflation since spring. Well, lesson learnt: It seems that the media is a lagging indicator....
Coming to the first question, the easiest way to search for deflation is to look at what markets are reflecting. A Bloomberg chart that has been circulating around the web a lot during the last couple of days compares yields between bonds that provide protection against inflation and those that don't to show that most all major economies are heading towards deflation. For the US, the five-year break-even rate suggests that investors are expecting annualized inflation to be -0.70% over the next five years.
However, there are a number of issues with using such yield differentials to measure expected inflation. For starters, there are issues about liquidity: Not only you are comparing apples and oranges (assets with different liquidity), because of structural changes in the bond market, you might be looking at Florida oranges while in fact you are chewing on the local Finike variety.
Moreover, if you control for liquidity, if people are risk-averse, the yield differential would include an inflation risk premium, giving an upward bias to inflation expectations derived from yield curve differences. I guess you could estimate this risk premium (and then scrap it to get at true inflation expectations) using volatility implied in options prices. But I am not sure if there are options on inflation...
The take from all this is that I would not put my money on deflation just based on bond yields. But there are other signs pointing towards deflation, as I will argue on my next entry on this topic...
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