Competitive Theories: “Deflation Warning” vs. “Inflation is Nearly Everywhere”

Courtesy of Mish.

Theory #1: Break-Even Rates Provide “Deflation Warning”

Bloomberg is sounding a Deflation Warning as 2-Year Break-Even Rates Go Negative.

Break-even rates are the difference between treasuries and the same-duration Treasury Inflation-Protected Securities (TIPS). The break-even rate turned negative yesterday for the first time since 2009.

In theory, break-even rates reflect investors’ expectations for inflation over the life of the securities.

When break-even rates are negative, it’s an indication investors expect price deflation for the duration, in this case for two years.

From Bloomberg …

The drop in the break-even rate followed a Labor Department report yesterday that showed consumer prices dropped 0.3 percent in November, the most in almost six years, on tumbling energy prices. Principal and interest payments on Treasury Inflation Protected Securities are indexed to changes in the consumer price index, so a lower than forecast CPI diminishes the value of projected future payments from TIPS.

The break-even rate dropped to negative 0.035 percent yesterday. The difference was 0.024 percent today.

The negative break-even rate represents “an uncertainty premium that maybe oil could fall to $40 a barrel,” said Donald Ellenberger, who oversees about $10 billion as head of multi-sector strategies at Federated Investors in Pittsburgh. “The shortest-term TIPS are very influenced by the direction of the consumer price index. It’s telling you inflation on the short-end could turn negative.”

Fed Chair Janet Yellen downplayed the notion at the press conference after the conclusion of yesterday’s two-day policy meeting. Falling break-even rates may represent a decline in the inflation premium risk or the range of inflation outcomes investors are taking into consideration, she said. One of the justifications for the Fed to raise rates for the first time since 2006 is to keep consumer price increases from getting out of control.

Out of Control Consumer Prices?

Color me extremely skeptical regarding out of control consumer prices. In fact, I side with this headline: Krugman, Fighting Consensus, Says 2015 Fed Rate Increase Is Unlikely.

Paul Krugman, challenging the consensus of economists and the Federal Reserve’s forecasts, said policy makers are unlikely to raise interest rates in 2015 as they struggle to spur inflation amid sluggish global economic growth.
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