Two metrics in particular are attracting the attention of Fed and ECB policymakers
Joe Rennison in New York
ECB president Mario Draghi, left, with US Federal Reserve chairman Jay Powell. After the ECB and Fed signalled earlier this month that they may be open to more accommodative monetary policies to support markets, inflation expectations jumped © AP
The European Central Bank and the US Federal Reserve have both opened the door to easing monetary policy, succumbing to fears about slowing global growth and fading inflation expectations.
In particular, two metrics have received a lot of attention: European five-year five-year swaps — typically written “5y5y” — and US break-evens. But what are they? What do they tell us? And why are central banks paying them so much attention?
Firstly, what is inflation?
In simple terms, it’s about prices rising for goods and services. That could be how much consumers pay at the supermarket for a loaf of bread or the cost of oil for industrial companies.
The effect of inflation is to reduce the purchasing power of money. Basically, goods cost more.
Central bankers typically try to keep inflation low but above zero, with both the ECB and Fed targeting a rate of about 2 per cent annually.
Current inflation is measured in a variety of ways. The Fed pays the most attention to the personal consumption index (PCE), tracking how much consumers pay for a range of household items. The ECB looks at the consumer price index (CPI), a similar measure that tracks price changes on a basket of goods and services.
Both measures have been lagging behind the central banks’ targets lately.
So why do we need these other measures of inflation?
Measures that collate recent data — such as PCE and CPI — are fine for giving policymakers a sense of what inflation is like now, but they do not offer insights into the outlook.
For that, investors and policymakers turn to 5y5y swaps and break-even inflation rates.
The 5y5y swap rate is a market measure of what five-year inflation expectations will be in five years’ time. It gives a window into how expectations for inflation may change in the future, which tells policymakers whether markets are convinced a central bank has the tools to keep the inflation rate within its set target.
The US 10-year break-even rate is slightly different. It measures what investors think inflation will be in 10 years’ time, derived from inflation-protected government securities. If inflation erodes the value of an investment, so goes the theory, then investors want to be paid more now to account for that. This “inflation compensation” is effectively what is represented in the break-even rate.
Why have these measures been getting so much attention?
Primarily because they have dropped so precipitously.
Earlier this month Mario Draghi, the ECB president, said he was taking the sharp move lower in 5y5y swaps “seriously”. The rate has fallen from 1.6 per cent at the start of the year to a low of 1.22 per cent this month.
The 10-year US break-even rate has this year dropped from 1.98 per cent in April to a low of 1.62 per cent in June. When the Fed met in May several participants commented that if inflation expectations did not move higher soon then the rate could become anchored below the Fed’s 2 per cent target.
“If inflation break-evens don’t move back toward 2 per cent from here that really starts to incentive easing,” said Jon Hill, an interest rate strategist at BMO Capital Markets. “Inflation expectations matter for current inflation. You price to it today. It is concerning how low these levels have been.”
Are there drawbacks to these measures of inflation expectations?
Central bankers certainly prefer to focus on current conditions. Measures of expected inflation are predictions — and policymakers sometimes disagree with what the market is telling them.
Furthermore, inflation expectations see-saw a lot more than actual measures of inflation. The primary driving force lately has been the ongoing trade war between the US and China, with investors fearing it could dampen global growth.
After the ECB and Fed signalled earlier this month that they may be open to more accommodative policies to support markets, inflation expectations jumped. The 5y5y rate rose back up to 1.30 per cent while the 10-year US break-even rate hit 1.78 per cent.
Both measures are also susceptible to movements in the price of oil, given crude prices are a large input in how each is calculated. Rising energy prices typically correspond with rising inflation expectations, and vice versa.
“The correlation between break-evens and the spot price of oil is extremely high,” said Seth Carpenter, chief US economist at UBS. “You have to tell a completely convoluted story about why the current oil price should affect the growth rate of all prices ten years from now. It doesn’t make sense. That alone means you should very much downplay break-evens, if pay attention to them at all.”
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