March 2, 2016 / 7:00 AM / 3 years ago

Sub-zero central banks may just chase inflation expectations lower

LONDON (Reuters) - Hyperactive central banks warn of ‘unmoored’ inflation expectations but may well be weighing the anchor themselves.

The headquarters of the European Central Bank (ECB) is pictured in Frankfurt, Germany, July 15, 2015. REUTERS/Kai Pfaffenbach

Skewed by the oil price collapse of the past 20 months, headline inflation rates across Europe and Japan are currently near zero or even falling. Some economists now expect euro zone inflation for 2016 as a whole to be in the red and no longer dismiss the development as temporary monthly blips.

Fearful these low inflation rates might distort consumer and business behavior into putting off consumption today and wait for cheaper goods in future, central banks are scrambling to steer expectations back to inflation targets of about 2 percent.

And the only way they seem to be able to achieve that is by being as aggressive as possible in easing monetary policy to try and convince everyone they will eventually succeed in their goals.

The European Central Bank and its peers in Japan, Switzerland, Sweden and Denmark have all pushed their interest rates into negative territory and insist they will go further if needed. The ECB, for one, is widely expected to cut its minus 0.3 percent deposit rate next week by at least 10 basis points.

But if future inflation expectations are what policymakers are trying to buoy, it’s not working and there’s a growing chorus of concerns that negative interest rates may actually be feeding the problem.

By undermining banks’ profitability - hence their balance sheets and willingness to lend - or even encouraging hoarding of physical cash to avoid deposit fees, financial markets at least have become unnerved about sub-zero interest rates and their unintended consequences.

“The road to Hell is paved with good intentions,” said Pictet Wealth Management’s head of asset allocation, Christophe Donay. “The implementation of negative interest rates by the BoJ and the ECB had quite the opposite result, rekindling deflationary fears through a shock to banks’ profitability.”

But there may also be a more mechanical distortion that adds fog to the horizon, reduces visibility and raises fears of a policy accident. It’s possible that as interest rates and bond yields go negative, they start to drag down gauges of inflation expectations, too and policy then just ends up chasing its tail.

Part of the problem is how central banks read the imprecise world of inflation expectations and whether their usual monitoring through the prism of government bond markets is still adequate in a climate of negative nominal yields.

So-called inflation ‘breakevens’ deduce a market view of future inflation by comparing nominal bond yields with those on inflation-protected bonds that promise a return regardless of inflation.

The measure previously favored by the ECB - the five-year, five-year breakeven forward rate, designed to measure average inflation between 2020 and 2025 - paints a truly alarming picture of faith in the ECB’s ability to rekindle inflation back to its target at any stage over the coming decade.


Since the ECB last cut its already negative deposit rate in December, this inflation gauge has spiraled about 45 basis points lower to as low as 1.36 percent this week. It’s shown no sign of turning despite a recovery in world oil prices last month and growing expectations of deeper ECB deposit rate cuts and more stimulus.

“The market is really challenging the ability of the ECB to create inflation at any point in the future,” said Semin Soher, senior portfolio manager at Pioneer Investments. Difficulty getting the euro lower and perceptions the ECB had not been aggressive enough, early enough were possible reasons, she said.

But Scott Mather, a chief investment officer at the global bond fund PIMCO, reckons there may be a distortion in inflation-linked bond markets when nominal cash yields are dragged toward or below zero and both the inflation components as well as the residual real yields are then both pulled lower.

“They would like to believe they would only pull down the real component and leave the inflation component unchanged, but it doesn’t work that way,” he said, adding there is a limit to how long investors will lend at such negative real yields. “By continuously forcing down nominal yields you are forcing down what is embedded for inflation expectations in the market.”

This depression of all components of what’s contained in bond yields can create spiral with over-mechanistic central banks, he said.

“If real economy actors didn’t have the bond market to look at, it is very likely that their inflation expectations would not be falling,” said Mather. “But they are constantly reminded of what the bond market is pricing because the central banks themselves are obsessed with it.”

Although there is no agreed gauge of household inflation expectations in the euro zone, surveys elsewhere do show them tallying broadly with the market-based readings - slightly higher in the United States, slightly lower in Britain.

And yet for all the head-scratching, some analysts feel market-based inflation expectations may simply be undermined by lack of demand for inflation-protected products in such a low deflationary environment. As a result, pricing is just working off the prevailing monthly inflation rate.

Businessmen walk past the Bank of Japan (BOJ) headquarters in Tokyo, Japan, February 15, 2016. REUTERS/Thomas Peter

“Over the last five years, spot inflation has been the best predictor of inflation breakevens,” said Dariush Mirfendereski, global head of inflation trading at HSBC.

“This seems odd because it is backward looking and not forward looking, but it is to do with market psychology, because the greatest demand for inflation products comes when realized inflation prints high,” he said. That is one reason the ECB may well just turn a blind eye and wait for its policies to filter through to real prices instead.

(This version of the story corrects gender of analyst in paragraph 14)

Graphic by Nigel Stephenson, editing by Larry King

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