By Min Zeng
An inflation gauge closely watched by Federal Reserve officials
has fallen to the lowest level since the financial crisis,
potentially complicating the interest-rate outlook as investors
brace for a likely Fed rate increase as soon as mid-2015.
The five-year forward five-year inflation breakeven rate hit
2.0185% this month, the lowest since Dec. 31, 2008, according to
the latest data provided by Rabobank.
The gauge measures what the average inflation rate will be
during a five-year period starting from five years from today, in
this case between 2019 and 2024.
Inflation expectations are tumbling amid uncertainty over the
economic outlook in China, Europe and Japan. While investors
generally prefer lower inflation because it helps preserve the
value of their assets, officials around the globe are wary of
deflation, a damaging cycle of falling prices and reduced spending
that can hamstring economic growth.
The falling inflation expectations help to explain the sharp
decline this year in benchmark Treasury yields. The 10-year U.S.
note on Tuesday yielded 2.22%, down from 3% at the end of 2013 and
far below the forecasts that many Wall Street strategists started
the year with. Many investors and analysts continue to expect
yields to rise this year as U.S. growth picks up, though falling
inflation readings have softened many of the most aggressive
forecasts.
Adding to the swirl, a broad selloff in the energy markets since
the summer has further reduced inflation readings. Many economists
expect lower oil prices to boost growth in the U.S. and elsewhere,
but the timing of the gains is unclear.
To be sure, few expect the U.S. will slip into deflation. But
market analysts say falling inflation readings could further slow
Fed plans to raise the fed funds rate, which has been near zero
since the crisis.
"With inflation benign, the Fed has breathing room and the
luxury of remaining patient," said Sean Simko, head of fixed-income
management at SEI Investments in Oaks, Pa., which has $146 billion
in assets under management.
Some other market-based inflation expectation gauges in the U.S.
government bond market have fallen below the Fed's 2% target. The
five-to-10-year inflation outlook from the monthly University of
Michigan/Thomson Reuters consumer sentiment survey last month fell
to 2.6%, the lowest level since 2009.
"With Japan and Europe still actively trying to generate
inflation, the Fed will not want to stall their own progress on the
same," said William O'Donnell, head of U.S. government bond
strategy at RBS Securities Inc.
While Fed officials have taken note of low inflation
expectations, Fed Vice Chairman Stanley Fischer and New York Fed
President William Dudley highlighted last week the benefits of
lower energy prices to the U.S. growth outlook. Cheaper energy
costs allow U.S. consumers to spend more money on other items.
Mr. Fischer said lower inflation driven by lower oil "is going
to be temporary." Mr. Dudley said that inflation will begin to move
up towards the Fed's 2% objective next year. The views suggested
the central bank is prepared to raise interest rates in 2015, said
analysts.
Interest rate futures markets show many investors expect the Fed
to start raising interest rates during the second half of next
year. Economists at Goldman Sachs Group Inc. expect the Fed to
raise rates in September 2015.
But Mr. O'Donnell said the Fed could push out the timing of an
interest-rate increase to 2016 if inflation remains below 2%.
Write to Min Zeng at min.zeng@wsj.com
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