Whatever else happens while the Federal Reserve brings the country back to normal monetary policies over the next few years (assuming we don’t get caught in a QE Trap as some critics fear), we don’t have to worry about the US getting stuck in a deflationary spiral because the Atlanta Fed assures us that the chance of deflation is still zero.
Using 5 and 10-year TIPS to gauge deflation
“The 2013–18 deflation probability—based on the 5-year TIPS issued in April and the 10-year TIPS issued in July 2008—was 0 percent on August 6, where it has been since early September 2013,” says a report from the Federal Reserve Bank of Atlanta. “The 2012–17 deflation probability is also 0 percent as of August 6.”
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The idea is that by comparing the yields on different Treasury Inflation-Protected Securities (TIPS) with the same maturity date you can separate out the real and nominal yields to figure out how much inflation the market expects to see over the next few years. If you add in a couple assumptions on how market participants are modeling inflation, you can also put a probability on whether inflation will slide into deflation.
Deflation not a common concern, but it’s not impossible
Most analysts are nearly as worried about seeing deflation in the US as they are in Japan and the eurozone (though you can find some people warning against it), but calling the probability actual zero seems extreme. Aside from normal warnings about putting too much trust into complicated models of the market and stating your conclusions with too much precision, the end of tapering is bringing the US monetary policy into unknown territory. Strong disagreements on what the neutral Fed funds rate will be going forward, for example, shows that neither the Fed nor market participants can say with certainty what’s going to happen next.
What this really means is that if the market is modeling inflation the way the Fed thinks is reasonable, then it isn’t pricing deflation into TIPS at all. That’s probably a useful thing for bond traders and other market participants to know, but this wouldn’t be the first time that the market got it wrong as a handful of bears warned that something was wrong. That should be enough to push the probability above zero.