Inflation Expectations Fall, Making Rate Hike 'More Difficult to Justify'

     

By Min Zeng
        A measure of U.S. inflation expectation in the bond market tumbled Thursday to the lowest level in nearly five months as U.S. crude oil prices fell to near the lowest level of 2015, potentially complicating the Federal Reserve's plan to raise short-term interest rates for the first time since 2006.
        The 10-year breakeven rate, or the yield spread between the 10-year Treasury note and the 10-year Treasury inflation-protected security, was recently at 1.66 percentage point, the lowest level since March.
        The level suggests investors expect the U.S. inflation rate to be running at an annualized 1.66% on average within a decade, down from 1.92% a month ago and below the Fed's 2% target deemed as appropriate for price stability for the economy.
        The latest development highlights the challenge the Fed is facing in crafting its fresh tightening cycle amid sluggish global growth, subdued inflation and highly accommodative monetary policy around the globe.
        Fed officials have deemed lower energy prices, which are keeping inflation low, as a transitory factor. Fed Chairwoman Janet Yellen said last month she expects the inflation rate to rise to 2% in the medium term. Yet many investors and analysts are worried that lower commodities prices on everything from oil and iron ore to silver and gold could derail the Fed's goal.
        "It begs the question, what is the Fed looking at that gives them the confidence inflation will be moving towards 2% because the market is sending a different message," Chris Bury, head of US rates trading in New York at Jefferies LLC. " "If they hike in the face of lowering inflation expectations, it risks damaging their credibility because their guidance to the market has been that they would wait for confident signs of inflation moving towards their 2% target.
        Weaker inflation expectation boost demand for Treasury bonds Thursday, sending the yield on the benchmark 10-year Treasury lower to 2.227%, near a two-month low, from 2.27% Wednesday. Yields fall as prices rise.
        Inflation is the main threat to the value of longer-dated bonds as it chips away bonds' fixed return over time.
        Policymakers and investors globally are grappling with still very low inflation levels.
        The Organization for Economic Cooperation and Development said Tuesday the annual rate of inflation in its 34 members was unchanged at 0.6% in June, well below the 2.0% regarded by most central bankers in developed economies as consistent with healthy economic growth.
        Thursday, the Bank of England halved its inflation forecast to 0.3% this year partly due to lower oil prices, a move investors interpreted as a signal that a rise in the U.K. interest rate is unlikely to happen this year.
        Meanwhile, in the U.S., solid jobs growth has bolstered the case for the Fed to raise interest rates as soon as September. In their rate statement accompanying the policy meeting in late July, they said some further improvement in the labor market could be sufficient for a rate increase.
        Some analysts say moving the rates away from the zero would give the Fed some breathing room. Should the U.S. economy lose momentum and the Fed find itself needing to support growth again, they can cut rates.
        Yet many investors are concerned that the Fed's rate-increase cycle, even at a measured pace, could hurt U.S. economic growth and prevent inflation from hitting the 2% target. The inflation gauge has been running below the Fed's target for 38 straight months.
        "The latest dip in oil and other commodity prices, along with the associated decline in long-term inflation expectations, will make it even more difficult to justify a tightening move in September," said James DeMasi, chief fixed-income strategist at Stifel Nicolaus & Co.
        More likely, says Mr. DeMasi, the Fed "will want to wait another few months to see if the recent dip in commodities is transitory and broader measures of inflation show some upward momentum toward the Fed's 2.0% target."
        Lower commodities are not the only factor containing U.S. inflation. A stronger U.S. dollar--driven by the Fed's pending shift into higher interest rates--is hurting U.S. exports and has lowered prices of imported goods.
        Some investors point out that market-based inflation expectations are mainly driven by energy prices, and note that some survey-based inflation expectations ticked higher last month. U.S. consumers expect the inflation rate to be running at 2.8% over the next five to 10 years in July, compared with expectations of 2.6% in June, according to the consumer sentiment survey from the University of Michigan.
        "I don't think inflation will stop Fed" from raising rates as soon as next month, said Zhiwei Ren, managing director and portfolio manager at Penn Mutual Asset Management Inc. which has $20 billion assets under management. "Inflation is usually a lagging indicator. The Fed is aware of it. The next two job reports are still the key" to the timing for an interest-rate increase.
        The first of those jobs reports hits Friday.
        (END) Dow Jones Newswires

        August 06, 2015 11:28 ET (15:28 GMT)

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