New Fed Policies and Market-Based Inflation Expectations
Market-based measures of inflation expectations reflect what investors anticipate inflation will be in the future. These measures rose in the days after September 13, when the Federal Reserve announced a third round of large-scale asset purchases and decided to keep the target range for the federal funds rate at an exceptionally low level at least through mid-2015. This round of asset purchases, unlike its predecessors, is open-ended, meaning it will continue until the outlook for the labor market improves substantially.
Immediately after the announcement, speculation arose that the new policies would push inflation higher than the target rate. Yet between then and now, market measures of inflation expectations have fallen considerably. This change suggests that market participants are now not expecting the new policies to boost inflation across any time horizon.
The spike in inflation expectations in the days surrounding the September announcement shows up in measures that are based on a range of short-term and long-term rates of different maturities. The peak occurs almost invariably either on the day of the announcement or on the day following it, as the rightmost vertical markers in the charts below show.
Some rates—more specifically, some forward rates—buck the trend by hitting their respective peaks just a handful of days later. Forward rates focus on a period between one point in the future and another point even farther in the future. Their appeal to analysts is that they give a view of future inflation that abstracts from current short-term shocks. For example, the 10-year, 10-year forward inflation swap rate was 3.3 percent on September 14. This means that on that day, market participants expected inflation to average 3.3 percent during the decade starting in 10 years.
Inflation expectations fell quickly after the September announcement. By the tenth day after the announcement, all measures had returned to the same band in which they were prior to the announcement, effectively erasing nearly all traces of the increases. For example, the same 10-year, 10-year forward inflation swap rate that we mentioned earlier stood at 2.9 percent on October 1, which is where it was prior to the September 13 announcement.
Taken in isolation, this sharp increase and rapid decline in expectations might seem rare and merit special attention. This is not the case. For example, data on the various measures of inflation expectations since the beginning of 2011 exhibit unmistakable spikes and dips. These are most pronounced in the short-term data—which makes sense, because short-term expectations react more forcefully to shocks than do longer-term ones. In contrast, the data on forward rates, which are not given to short-lived swings, vary less.
What we see from these market-based measures of inflation expectations is that markets are putting negligible weight on a high inflationary environment in the medium- and long-term future. In fact, these expectations have settled near their preannouncement levels. Of course, we cannot associate all the swings in the measures with the Fed’s policy announcements. Like any other macroeconomic variable, expectations are affected by other variables and beliefs about future economic conditions. It is very hard to disentangle the effects of such assessments from announcements of policy changes. However, looking at the data, it seems that market participants who actually bet their money on the future inflation outlook do not see an inflationary threat in the Fed’s new policies.