Diminished expectations

Chart of the week

Inflation expectations have been trending downwards in recent months. The reasons for the decline are far from straightforward.

Odd things have recently been happening in government bond markets. Since the start of the year, the U.S. Federal Reserve (Fed) has pivoted away from further interest-rate hikes. The trade war between the U.S. and China has escalated. And the oil price has gone up sharply. All three of these factors might usually be expected to boost longer-term inflation expectations. Most obviously, pricier oil and higher tariffs on Chinese imports will ultimately mean higher prices for American consumers. Instead, market inflation expectations have fallen. Our "Chart of the Week" shows the five-year-five-year-forward breakeven rates. These provide a useful measure of average inflation expectations in five years' time. Normally, they have tended to move in tandem with the spot price for oil. Lately, a gap has opened up.

For now, it remains unclear why. Perhaps, oil prices will correct leading the two curves to converge. Or maybe, investors have grown more doubtful about U.S. growth prospects. Certainly, the effects of an escalating trade war are likely to go well beyond the initial, transitory consumer-price hikes. Tariffs and other protectionist measures make the world as a whole less efficient in producing goods and services. However, you would usually expect to see early signs of this in real interest rates, which are closely tied to an economy's longer-term real growth rate, rather than in inflation expectations.

We have an alternative explanation. Perhaps, the real mystery behind our Chart of the Week is not about why the relationship between inflation expectations and the oil price has broken down but why it has held up fairly well in the past. Actually, there is no clear economic reason why today's oil price should matter for inflation in five years, let alone for long-term inflation expectations. However, there are few other reliable indicators available in markets so far out. The recent obsession with inflation expectations reminds us a little of the 19th century quest to identify a link between sunspot activity and corn prices. No statistically reliable relationship has yet been found between the sun and the business cycle, though sunny weather does appear to sometimes improve the mood of financial investors. According to more recent economic theorizing such seemingly spurious relationships can be quite powerful, if they entail an element of self-fulfilling prophecy.

Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 5/21/19

* 5-year/5-year U.S. dollar inflation swap rate

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