Investors boost bets on benign U.S. inflation - Fed study

SAN FRANCISCO Mon May 12, 2014 1:00pm EDT

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SAN FRANCISCO May 12 (Reuters) - Investors are boosting bets that U.S. inflation will return to normal levels over the next few years, according to a study published Monday by the Federal Reserve Bank of San Francisco.

"Market participants seem to view a favorable inflation outcome as increasingly likely," San Francisco Fed economists Michael Bauer and Jens Christensen wrote in the latest issue of the bank's Economic Letter. "The odds of inflation outcomes consistent with the (Fed)'s notion of price stability are more favorable than they have been for the past several years."

Options contracts that pay out when inflation misses the Fed's 2-percent target put the 'risk-neutral' probability of normal inflation over the next year at about 40 percent, the study showed. The contracts, called inflation caps and floors, pay off only if inflation rises above, or falls below, a given threshold before the contract expires.

That compares to the 24 percent probability assigned at the end of 2012 and the 17 percent probability assigned at the end of 2011.

But the analysis also showed that investors are hedging heavily against less desirable outcomes, particularly the possibility that inflation will continue to undershoot the Fed's 2-percent target.

Options prices assign a 40-percent risk-neutral probability that inflation will undershoot the Fed's target over the next year, and a 20-percent probability to too-high inflation, the study showed.

The study's authors cautioned that risk-neutral probabilities are not the same as 'real-world probabilities' because they tend to assign higher-than-plausible odds to extreme outcomes with serious adverse consequences, such as deflation or hyperinflation.

Still, the authors said, policymakers are worried about adverse outcomes as well, and "an argument can be made" that they include such risk-neutral probabilities as they make their own forecasts and policy decisions.

In any event, they concluded, "the economy is likely to face low inflation for some years to come." (Reporting by Ann Saphir; Editing by James Dalgleish)

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