Market-based Estimates: What’s wrong with 2%?
The bond market offers more clues on inflation expectations with “breakevens,” the difference between nominal yields and yields on inflation-linked bonds (TIPS). Inflation expectations in the medium term can be measured—going five years in the future—with the closely watched five-year forward breakeven rate. Since holding at a stable 2.5% early in the year, the indicator dropped below 2% in August. Even though 2% is the long-term goal, the Fed would like to see higher medium-term inflation expectations before removing the unprecedented post-crisis stimulus.
It is important that the economy be strong enough to produce its own inflation, rather than the artificial inflation spawn from the various rounds of quantitative easing. In reality, whether we analyze survey-based or market-based estimates (neither are perfect), the narrative is that present and forward inflation is not traveling in the right direction.
Why does this matter to investors? Declining inflation expectations may stymie growth, hurt valuations, impede corporate profitability and erode investor confidence. For now, too little inflation remains a bigger risk than too much.
Terry Simpson, CFA, contributed to this post. He is a Global Investment Strategist for BlackRock.
Source: Bloomberg.
Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog and you can find more of his posts here.