Saturday, October 3, 2015

Forward rate inflation forecasts - bankrupt signals?


The folks at Bespoke Research provided an insightful chart on the break-even forward curve for inflation expectations. The Fed and other central banks as well as many market watchers focus on these forward expectations as the best guess of what will happen to inflation. It is a market based forecast so it should be represent the bets guess on inflation. As part of the rational expectations revolution, it is natural to believe that forward curve break-evens are rational and would be unbiased estimates of futures inflation. 

If the forward expectations fall, then we are in trouble with the inflation problem. The idea with many central bankers is that if expectations start to embed a deflation bias it will be all the harder to get a lift-off to higher growth in the economy. It is just one more tool or reason for the Fed to wait on raising rates.

Well, a close look at the different forward rate expectations tell a very confusing story. First, the expectations can be very volatile. They can change quickly. Second, there is nothing smooth about the transitions across time. Inflation is all over the map and there is no clear trend transitions from one year to the next. Third, the forecasts can give wild estimates that move to extremes. All of this suggests that these break-evens are not always rational and will be affected by short-term psychology or changes in data that suggest a change in inflation. Markets seem to over-react to short-term inflation on inflation. 

It should be hard pressed for anyone to use these forecast as an important tool for making inflation policy decisions. 

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