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 Skewed by the oil price collapse of the past 20 months, headline
inflation rates across Europe and Japan are currently near zero or
even falling. Some economists now expect euro zone inflation for
2016 as a whole to be in the red and no longer dismiss the
development as temporary monthly blips.
Fearful these low inflation rates might distort consumer and
business behavior into putting off consumption today and wait for
cheaper goods in future, central banks are scrambling to steer
expectations back to inflation targets of about 2 percent.
And the only way they seem to be able to achieve that is by being as
aggressive as possible in easing monetary policy to try and convince
everyone they will eventually succeed in their goals.
The European Central Bank and its peers in Japan, Switzerland,
Sweden and Denmark have all pushed their interest rates into
negative territory and insist they will go further if needed. The
ECB, for one, is widely expected to cut its minus 0.3 percent
deposit rate next week by at least 10 basis points.
But if future inflation expectations are what policymakers are
trying to buoy, it's not working and there's a growing chorus of
concerns that negative interest rates may actually be feeding the
problem.
By undermining banks' profitability - hence their balance sheets and
willingness to lend - or even encouraging hoarding of physical cash
to avoid deposit fees, financial markets at least have become
unnerved about sub-zero interest rates and their unintended
consequences.
"The road to Hell is paved with good intentions," said Pictet Wealth
Management's head of asset allocation, Christophe Donay. "The
implementation of negative interest rates by the BoJ and the ECB had
quite the opposite result, rekindling deflationary fears through a
shock to banks' profitability."
But there may also be a more mechanical distortion that adds fog to
the horizon, reduces visibility and raises fears of a policy
accident. It's possible that as interest rates and bond yields go
negative, they start to drag down gauges of inflation expectations,
too and policy then just ends up chasing its tail.
Part of the problem is how central banks read the imprecise world of
inflation expectations and whether their usual monitoring through
the prism of government bond markets is still adequate in a climate
of negative nominal yields.
So-called inflation 'breakevens' deduce a market view of future
inflation by comparing nominal bond yields with those on
inflation-protected bonds that promise a return regardless of
inflation.
The measure previously favored by the ECB - the five-year, five-year
breakeven forward rate, designed to measure average inflation
between 2020 and 2025 - paints a truly alarming picture of faith in
the ECB's ability to rekindle inflation back to its target at any
stage over the coming decade.
CHALLENGING THE ECB
Since the ECB last cut its already negative deposit rate in
December, this inflation gauge has spiraled about 45 basis points
lower to as low as 1.36 percent this week. It's shown no sign of
turning despite a recovery in world oil prices last month and
growing expectations of deeper ECB deposit rate cuts and more
stimulus.
"The market is really challenging the ability of the ECB to create
inflation at any point in the future," said Semin Soher, senior
portfolio manager at Pioneer Investments. Difficulty getting the
euro lower and perceptions the ECB had not been aggressive enough,
early enough were possible reasons, she said.
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But Scott Mather, a chief investment officer at the global bond fund
PIMCO, reckons there may be a distortion in inflation-linked bond
markets when nominal cash yields are dragged toward or below zero
and both the inflation components as well as the residual real
yields are then both pulled lower.
"They would like to believe they would only pull down the real
component and leave the inflation component unchanged, but it
doesn't work that way," he said, adding there is a limit to how long
investors will lend at such negative real yields. "By continuously
forcing down nominal yields you are forcing down what is embedded
for inflation expectations in the market."
This depression of all components of what's contained in bond yields
can create spiral with over-mechanistic central banks, he said.
"If real economy actors didn't have the bond market to look at, it
is very likely that their inflation expectations would not be
falling," said Mather. "But they are constantly reminded of what the
bond market is pricing because the central banks themselves are
obsessed with it."
Although there is no agreed gauge of household inflation
expectations in the euro zone, surveys elsewhere do show them
tallying broadly with the market-based readings - slightly higher in
the United States, slightly lower in Britain.
And yet for all the head-scratching, some analysts feel market-based
inflation expectations may simply be undermined by lack of demand
for inflation-protected products in such a low deflationary
environment. As a result, pricing is just working off the prevailing
monthly inflation rate.
"Over the last five years, spot inflation has been the best
predictor of inflation breakevens," said Dariush Mirfendereski,
global head of inflation trading at HSBC.
"This seems odd because it is backward looking and not forward
looking, but it is to do with market psychology, because the
greatest demand for inflation products comes when realized inflation
prints high," he said. That is one reason the ECB may well just turn
a blind eye and wait for its policies to filter through to real
prices instead.
(This version of the story corrects gender of analyst in paragraph
14)
(Graphic by Nigel Stephenson, editing by Larry King)
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