Analysis: On inflation, central bankers shouldn’t take the market at its word



Banknotes of various currencies including the euro, US dollar, Turkish lira or Brazilian reais are pictured in Frankfurt, Germany in this illustrative photo taken on May 7, 2017. REUTERS / Kai Pfaffenbach / Drawing

  • The 5-year inflation measure has an excessive correlation with oil prices
  • Central banks look for alternative indicators

FRANKFURT, Nov. 1 (Reuters) – Investors anticipate the highest inflation rates in decades for the United States and the eurozone, but central bankers might be well advised to take this with a pinch of salt given indicator faults.

The so-called five-year / five-year prospective gauge of market inflation expectations – or 5 years to 5 years for short – has reached 2% in the euro zone and its American counterpart is even above this threshold, which is that of the Federal Reserve and the European Central. The aim of the bank.

So should the two central banks just claim victory and start raising rates?

Not so fast.

Both indicators, which roughly measure the amount of compensation investors require to assume inflation risk over a 10-year period, are flawed.

For starters, they have a bad track record of predicting inflation when they have an odd correlation with oil price movements.

This flies in the face of economic logic since one measure is the price of a barrel of crude to be delivered in the short term while the other is a long term rate of change in aggregate prices.

The correlation may have to do with the inner workings of financial markets, where some investors use inflation-indexed products to hedge other transactions.

“Would the 5 to 5 year be a good predictor of future realized inflation? I don’t think so because it is correlated with oil futures, which are bad predictors,” said Ilia Bouchouev, managing partner at Pentathlon Investments and speaker in New York. University.

His company belongs to a niche of hedge funds that seek to exploit this correlation by simultaneously trading oil futures and inflation swaps when their prices diverge.

Additionally, the low trading volumes in the swap contracts that underpin the European 5a5y mean that a relatively small number of traders can influence its price, which can also be distorted by general market turmoil.

The ECB has long been aware of these and other limitations.

He warned as early as 2006 that inflation swaps “should not be interpreted as direct market expectations of future inflation rates” and concluded last summer that “market imperfections” amounted to 30 basis points. down 100 basis points to 5.5 years since 2008.

The US 5y5y were no better. Unlike its counterpart in the euro zone, it is based on what is called the breakeven point, that is to say the difference between the yield of treasury bills indexed to inflation and their nominal counterparts.

With the Federal Reserve holding nearly a quarter of the market in Inflation-Protected Treasury Securities (TIPS) and more than a fifth of the underlying Treasuries, some investors feel the 5 to 5 year is losing. of its importance as an indicator.

“The prices on break-even points are to a certain extent controlled, which implies for me that this is an imperfect mechanism either to obtain an estimate of the true inflation expectations of the market, or to perfectly hedge against inflation, ”Sonal Desai, chief investment officer for Franklin Templeton Fixed Income Group, said in a corporate podcast.

5 year / 5 year inflation swap vs Brent


The central bankers took a stick for their own back.

In 2014, then ECB President Mario Draghi sparked the market’s obsession with the Eurozone 5 to 5 year by elevating it as the preferred measure of central bank inflation expectations. in a speech paving the way for a massive bond purchase plan.

This may have contributed to the 5-year-old’s own disappearance based on Goodhart’s Law.

This law, named after British economist and former Bank of England policy maker Charles Goodhart and later reformulated by anthropologist Marilyn Strathern, states that when a measure becomes a target, it ceases to be a good measure. .

ECB chief economist Philip Lane and his fellow board member Isabel Schnabel have already started to complete the 5 to 5 year period with the probability, implicit in option prices, that inflation will be in certain areas. forks.

The old-fashioned forecasts of flesh-and-blood economists were also mentioned by policymakers.

Eurozone inflation is expected to hit 1.8% next year and 1.6% in 2023 and 1.6% in 2024, according to Reuters poll – still not meeting the condition for the ECB to raise rates of interest, namely that the price growth is seen stably at 2%.

The Fed, for its part, even created an index of common inflation expectations that merges surveys and market prices. Read more

Yet ECB President Christine Lagarde and Fed Chairman Jerome Powell regularly cite market-based expectations, indicating their continued relevance.

Indeed, surveys can be immune to market turbulence, but they also have their drawbacks, such as limited sample size and relative scarcity.

“Ultimately all indicators have limits, so we go with the preponderance of evidence,” said Fritzi Koehler-Geib, chief economist at German state bank KfW.

Reporting by Francesco Canepa; Editing by Toby Chopra

Our Standards: The Thomson Reuters Trust Principles.


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