SAN FRANCISCO May 12 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
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
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
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)