mollyfamwatThe International Monetary Fund (IMF) has predicted that inflation in the eurozone is likely to hit 2.1 percent this year, up from 1.9 percent in 2014, according to a quarterly review of the 29 economies that use the euro as their currency. While some economists don’t think inflation will reach the ECB’s target of just below 2 percent, the IMF’s figures are just one indication that the eurozone’s economic recovery is likely to be weaker than expected.
An American friend recently told me that she is worried about the goings-on in the Eurozone. She is worried that the eurozone will suffer from deflation in the near future, which is the opposite of what the central banks want, and what she believes is happening. She told me that she was afraid that the euro would become a deflationary currency in the next few years. So, what is deflation?
Over the past few years, the Federal Reserve has implemented many new policies. These policies have resulted in very low unemployment rates, which have lowered the value of the dollar. As a result, many people are expecting lower dollar inflation rates, which in turn, lowers USD inflation expectations.
Inflation expectations could rise slightly.
Financial markets are signaling that investors are increasingly concerned about inflation. At the close of trading on Thursday, bond prices were assuming an average 2.6% increase in consumer prices over the next five years. In recent weeks, this measure of inflation compensation has reached a high not seen since 2008. This was helped by the announcement of an official US inflation rate of 4.2%, which is also a 13-year high. Participants in the May survey of fund managers of
Bank of America
consider inflation to be the biggest tail risk to the bull market.
But one risk is paying too much for inflation insurance.
The market’s inflation expectations are calculated based on the yield differential between regular Treasury securities and Treasury Inflation Protected Securities (TIPS), which compensate holders for increases in the consumer price index. Like
UBS
As U.S. interest rate manager Mike Cloherty noted in his report this week, it was the decline in TIPS yields that caused the recent break-even point. This close inverse correlation is reminiscent of the economic recession of 2009 to 2013, but is atypical of the recovery, during which the two indicators typically rise together.
TIPS are generally known to be less liquid, so their prices can fluctuate wildly when demand is high. This is currently the case: TIPS stocks at commercial banks are running low. The Federal Reserve, for example, buys them in large quantities. The yield on five-year bonds now stands at a record low of minus 1.8%. All this points to a turnaround.
As a result, the equilibrium value may overestimate the magnitude of inflation by increasing the demand for short-term inflation hedges. The CPI is still expected to rise sharply this year, while it is expected to fall sharply in 2020, and long-term forecasts for inflation are still within historical ranges. This picture is consistent with the Fed’s new policy, which tolerates short-term outperformance but ensures that inflation remains at 2% over the long term.
However, it would be wrong to pretend that the market is not concerned. Other traditional inflation hedges have performed very well recently, such as cheap value companies and gold, which is up 9% in two months. Investors know that there is no reliable way to guarantee that a short-term price spike will not lead to a more permanent spike. According to a University of Michigan consumer survey, households expect the consumer price index to rise 3.4 percent over the next five to 10 years, the highest level since 2014.
Nevertheless, as the Bank of America study argues, the current nervousness in the markets reflects fears of extreme risk rather than likely outcomes. Even among consumers, average inflation expectations are skewed by a few respondents who see the CPI rising by 10% or more, rather than by most households expecting higher inflation.
Shopper in Chicago this month. The University of Michigan consumer survey shows that households expect the CPI to be 3.4% over the next five to ten years.
Photo:
Nam Y. Huh/Associated Press
There is little convincing evidence for the widespread view among economists that expectations alone can drive inflation. Workers demanding wage increases in anticipation of inflation can indeed exacerbate the situation, but this requires an initial stimulus, such as the oil shock of the 1970s or a major currency devaluation. Even an exceptionally rapid economic recovery, such as the current one, does not normally fall into this category.
Investors who fear these catastrophic scenarios should nevertheless hedge against inflation. For the rest of us, they become an expensive insurance policy.
At the Wall Street Journal CEO Summit, Janet Yellen expressed confidence that the U.S. economy and employment will return to normal levels next year.
Email John Sindreu at [email protected].
Copyright ©2020 Dow Jones & Company, Inc. All rights reserved. 87990cbe856818d5eddac44c7b1cdeb8Inflation expectations are a measure of people’s expectations for the future annual rate of inflation. Inflation expectations are important because monetary policy is often based on the assumption that people will have an inflation target in mind when setting interest rates.. Read more about us inflation expectations and let us know what you think.
Frequently Asked Questions
How inflation expectations affect inflation?
Inflation is highly uncertain. According to the latest inflation figures, the consumer prices index (CPI) rose 0.2% in January, the same pace as in December. However, the latest forecasts, including those by the European Central Bank (ECB), are predicting a higher figure, of around 0.4%, for the year on year rate of price growth. In the short-term, how inflation is measured may influence how inflation is perceived. The Consumer Price Index (CPI) is the most widely used measure of inflation. However, it is only one of many methods. In the American economic textbooks you will often find a case study involving a group of business owners. One of them is a flower shop owner who sells flowers during a time of high inflation. The value of the dollar is constantly rising, so the flower shop owner is forced to accept and pay more for the flowers he is selling. His prices are high, but his customers are happy and he earns enough money to cover his expenses and that of his employees. However, when inflation is low and the value of the dollar is low, then his customers may not be willing to pay as much for the flowers and the flower shop owner may run out of money.
What happens when inflationary expectations increase?
Inflation expectations are an economic factor that measure people’s views of future economic conditions. The idea is that markets rely on economic expectations to make accurate predictions about the future. When inflation expectations are high, it usually means investors are expecting higher inflation, which in turn means they expect higher interest rates. When confidence is low, investors are expecting lower inflation, which means they expect lower interest rates. The Eurozone is often thought of as a place where inflation is high, but when you look at the numbers it doesn’t make too much sense. First of all, the Eurozone’s inflation rate has been running at negative 1.9% for the past 3 years, which is far lower than some other major economies such as the US and UK. This is despite the Eurozone’s weak economic recovery, and the fact that it is home to some of the highest levels of debt in the world.
What is the role of inflation expectations?
At the moment prices in the Eurozone are trending higher. So what’s going on? A few weeks ago, the minutes of the ECB’s May meeting were published, and they said that the members were well aware that there might be upward pressure on prices in the coming months, and that it was important to “keep an eye” on the development of inflation expectations. Part of the reasons for the higher inflation rates are that the unemployment rate is falling in the Eurozone and the number of people seeking employment is rising. In the UK the Bank of England has recently raised the base rate of interest from 0.5% to 0.75%, which may also lead to higher inflation. The Fed just released its latest review of inflation expectations for the year ahead, and they found that they have fallen, especially for the 12-month outlook. The Fed measures them monthly by taking the average of the expectations for 4 quarters, and then subtracting the average from the most recent reading. The Fed says it was closer to 2.9% in November compared to their forecast of 3.0%.
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