(Bloomberg) -- The former senior Federal Reserve official who helped change how the central bank assesses long-run inflation expectations says policymakers should continue to lean hawkish in their communications, or risk jeopardizing their hard-earned credibility when it comes to anchoring longer-term price pressures.
As head of monetary and financial market analysis at the Fed 20 years ago, Brian Sack advocated using a forward measure of inflation expectations to help guide monetary policy. Now, even with consumer prices rising at a 4.9% annual rate, he says the fact the so-called five-year, five-year forward breakeven inflation rate is hovering around 2.2% shows markets have confidence in the central bank’s ability to rein in prices over the longer-term. Still, he warns policymakers can’t take that trust for granted.
“It took a lot for the Fed to keep these inflation expectations contained, and they certainly want to maintain that,” said Sack, who earlier this year left D.E. Shaw & Co. after about a decade as head of the firm’s global economics group. “That makes them lean toward communicating in a hawkish direction at this point. They had to earn their inflation credibility, and it’s not a simple, stable equilibrium.”
Many Fed officials have signaled that the US central bank will likely keep interest rates steady when they gather next week, though traders predict at least one more hike before the current tightening cycle is over. Markets and policymakers will be keenly focused on the May consumer-price inflation reading set to be released June 13, the day before the Fed’s policy decision.
US central bankers have long maintained that expectations for inflation can ultimately drive actual price pressures, a key reason they work hard to not let them escalate.
Sack was among the prominent voices in 2021 who were prodding the Fed to shift to a policy-tightening stance amid signs longer-term inflation expectations were at risk of becoming unmoored.
The five-year, five-year forward breakeven rate had surged as the effects of monetary and fiscal stimulus, as well as an array of supply-chain bottlenecks, worked their way through the economy. The rate jumped to as high as 2.7% in April 2022, from less than 1% following the onset of the pandemic.
“Long-term inflation expectations were rising sharply before the tightening began because the market was starting to question the Fed’s credibility on fighting inflation,” Sack said. “However, once underway, the Fed managed to tighten at a fast enough pace to bring long-run inflation expectations down some and to keep them contained.”
The five-year, five-year inflation rate measures bond traders’ projection for average annual consumer price increases for the half decade period beginning in five years. It’s derived from yields on five- and 10-year on Treasury Inflation-Protected Securities as well as nominal government debt. The forward breakeven is calculated by using the gap between yields at the different maturities to extract where inflation for a particular period is anticipated to be in the future.
Part of the idea behind the five-year, five-year forward rate was to create a smoother read of inflation expectations, one that filters out the noise of the coming few years, Sack said.
The Fed, of course, looks at an array of measures to estimate inflation expectations, including surveys. It publishes a quarterly composite index constructed using 21 inflation expectation indicators — including the five-year, five-year rate.
‘Well Anchored’
The Philadelphia Fed’s most recent survey of professional forecasters showed economist expectations for the CPI inflation rate over the next 10 years dropping to a two-year low of 2.36%, from a peak of 2.95% at the end of 2022. A New York Fed survey of consumers also showed the expected average inflation rate for the next three years has retreated significantly since surging in 2021 and 2022.
Yet a University of Michigan survey measuring inflation expectations over the next five to 10 years remained elevated in May at 3.1%, matching the highest since 2011.
Minutes from the Fed’s May meeting revealed that “a few” central bank officials said that policy tightening and communications had helped keep inflation expectations “well anchored.” They added that this was “important” for achieving the Fed’s target.
Read More: The Fed Needs to Push US Interest Rates Higher: Bill Dudley
Gang Hu, managing partner at Winshore Capital Partners, which specializes in inflation-protected investments, says that the stability of the Fed’s five-year, five-year forward measure shows that the market is confident that the Fed will keep inflation under control.
“It is significant because if inflation expectations become unanchored, the Fed has to react and raise rates further,” likely to the point of “crashing the economy,” he said.
The following is a series of indicators on how the market views US inflation:
Inflation Snapshot
Inflation News Bites
- The Bank of Canada’s unexpected decision to resume raising interest rates upended markets and underscored the difficult task faced by central banks. The Reserve Bank of Australia also surprised investors with an interest-rate hike this week and the central bank’s boss said upside surprises in inflation are testing officials’ patience.
- European Central Bank officials called for interest rates to be lifted further — seeking additional reassurance on the inflation front — although consumer expectations for euro-zone inflation eased significantly in April.
- Brazil’s annual inflation slowed much more than expected in May.
- The global economy is set for a weak recovery from the shocks of Covid and Russia’s war in Ukraine, dogged by persistent inflation and the restrictive policies of major central banks seeking to contain price pressures, the OECD said.
- US Treasury Secretary Janet Yellen reiterated that she sees a “path” for inflation to come down while retaining a strong US job market. Meanwhile, The Fed’s inflation fight is also facing a new challenge: a dry Panama Canal.
Key Upcoming US Releases
- June 13: Consumer price index report for May
- June 14: Producer price index report for May; Federal Open Market Committee policy decision
- June 15: Import and export price indexes for May
- June 16: University of Michigan survey of inflation expectations
- June 29: Gross domestic product report for first quarter (third reading)
- June 30: Personal income and spending report, including PCE, for May
- July 3: Institute for Supply Management manufacturing survey, including prices paid
- July 7: Monthly jobs report, including wages
©2023 Bloomberg L.P.
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