US bond investors are showing no immediate worries about a resurgence in inflation, even though the Federal Reserve is thought to be close to adopting an official target for price growth as soon as next week. Though 10-year inflation expectations have risen 0.4 percentage point since last September, this is primarily seen as a recovery to normal levels after becoming depressed last year during the euro zone government debt crisis.
Now the market sees a 10-year inflation rate of 2.1 percent, based on the difference in yields on Treasury Inflation Protected Securities and conventional US government debt, which is a key gauge of expectations monitored by the Fed. That spread, called the breakeven inflation rate, is in line with the 2 percent rate markets have for some time seen as the Fed's unofficial target. "We are not getting any surge in inflation," Jim Vogel, interest rate strategist at FTN Financial in Memphis, Tennessee said on Friday.
If the Fed does adopt an explicit inflation target at its policy meeting next week, such a move would be aimed at holding inflation expectations to afford the central bank room to buy more bonds or introduce other stimulus measures to make sure the economy recovers. The Fed's policy-setting panel will meet next Tuesday and Wednesday.
Back in August 2010 - before the Fed signalled it was open to a large scale purchase of Treasuries, known as QE2 - the 10-year TIPS breakeven rate had fallen to 1.50 percent, a level which stoked fears of a crippling downward price spiral known as deflation. Much of the recent rise in the 10-year breakeven rate has been due to higher gasoline prices and encouraging US economic data, which have reduced anxiety about another recession. It hit its highest level since late October on Thursday.
The rise in the breakeven rate occurred even as the 10-year TIPS yield set a series of record lows in negative territory this week. Dealers and investors also bought a record amount of TIPS worth $15 billion at an auction on Thursday. The yield on the 10-year TIPS issue due in July 2021 was last bid at minus 0.122 percent on Friday after it touched a record low near minus 0.25 percent on Wednesday. Analysts attributed the negative TIPS yields to an intense safehaven bid for US government debt due to the nagging fiscal woes in Europe.
The festering euro zone debt crisis as well as the high US unemployment and a struggling housing market will likely keep a lid on inflation expectations, analysts said. This tame price outlook gives Fed officials breathing room so they can focus on helping the economy, especially with measures aimed at stimulating lending and to stabilise home prices, analysts said.
If the Fed adopts inflation targeting, it could boost the effectiveness of a third round of quantitative easing, said Eric Green, chief of US rates research and strategy at TD Securities. Green said the second round of quantitative easing was not as effective as intended because it was to narrowly defined in size and duration. The program fell short of achieving the goals of lowering unemployment and healing the housing market.
If the Fed could link QE3 with an inflation target, it would not boxed in like it did with the previous QE programs. "If the Fed ties policy to a specific target, then QE3 may prove to be more flexible, more open ended, and less easily gamed by a market that has had buying programs outlined in excruciating detail," Green wrote in a research note on Friday.