Things to Read for Your Afternoon Procrastination on January 14, 2016

Graph 5 Year 5 Year Forward Inflation Expectation Rate FRED St Louis Fed

Must-Read: Narayana Kocherlakota: Information in Inflation Breakevens about Fed Credibility: "The ten-year breakeven refers to the difference in yields between a standard (nominal) 10-year Treasury and an inflation-protected 10-year Treasury (called TIPS)...

...The five-year breakeven is the same thing, except that it’s over five years.... The five-year five-year forward breakeven is defined to be the difference between the 10-year breakeven and the five-year breakeven... shaped by beliefs about inflation over a five year horizon that starts five years from now... conceptually... the sum of... 1. investors’ best forecast about what inflation will average 5 to 10 years from now, [and] 2. the inflation risk premium over a horizon five to ten years from now.... My own assessment is that both components have declined. But my main point will be a decline in either component is a troubling signal about FOMC credibility.  

It is well-understood why a decline in the first component should be seen as problematic for FOMC credibility. The FOMC has pledged to deliver 2% inflation over the long run.... A decline in the first component of breakevens signals a decline in this form of credibility.... A decline in the inflation risk premium means that investors... increasingly see standard Treasuries as being a better hedge.... But Treasuries are only a better hedge than TIPs against macroeconomic risk if inflation turns out to be low when economic activity turns out to be low.... [Thus] a decline in the inflation risk premium... reflects investors’ assigning increasing probability to a scenario in which inflation is low over an extended period at the same time that employment is low....

In the world of policymaking, no signal comes without noise.  But the risks for monetary policymakers associated with a slippage in the inflation anchor are considerable.   Given these risks, I do believe that it would be wise for the Committee to be responsive to the ongoing decline in inflation breakevens by reversing course on its current tightening path.

https://sites.google.com/site/kocherlakota009/home/policy/thoughts-on-policy/1-14-16

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