Inflation expectations are jointly falling?

by Rebecca Wilder

As a global economic slowdown is very likely underway, inflation expectations are being watched closely.

David Beckworth comments on inflation expectations in the US using the Treasury Inflation-Protected Securities (TIPS) market (he commented previously on an alternate measure of inflation expectations at the Federal Reserve Bank of Cleveland). He argues that the aggregate demand effect is the dominant factor dragging US inflation expectations.

However, inflation expectations are falling globally. The chart above illustrates the 10-yr break-even expected inflation rates for the UK, Germany, Canada, Italy, and the US using their respective inflation-indexed bond markets (TIPS in the US). Notably, declining inflation expectations is not specific to the US.

Of interest, the onset of the downward trend across break-even inflation rates coincides with policy announcements in Europe:

1. the bailout of Greece, and
2. the European Financial Stability Facility (EFSF)

Inflation expectations in Italy has taken the biggest hit, falling 55 basis points since May 2 2010 (as of June 12, 2010). But the trend has been broad-based, hitting even “sticky” UK inflation expectations.

The chart illustrates the same 10-yr inflation expectations rates as in the first chart but indexed to the start of 2010 for comparison.

Market participants in the UK, Germany, Canada, Italy, and the US reacted similarly to the European policy measures. The most likely reason for the drop in Eurozone country inflation expectations – Germany and Italy – is the direct adverse impact on aggregate demand of fiscal austerity measures and the indirect impact via trade. In the UK, Canada, and the US, the decline in the euro will have lagged and adverse impacts on relative trade patterns.

However, beyond the adverse impact on expected export income, it does seem that markets over-reacted a bit in the UK, Canada, and the US. Because the UK, Canada, and the US have one thing that Germany and Italy don’t: fully sovereign policy. Domestic policy, monetary and fiscal, can offset the effects of the European crisis.

Rebecca Wilder