QE3 more plausible if inflation expectations keep falling

When it comes to the price stability half of their mandate, Federal Reserve officials have made one thing clear: they will not allow inflation expectations to veer very far from their preferred path. That’s because they believe inflation expectations are a good proxy for the pace of future price increases. This applies both to the upside, when rising prices are a problem, and when the opposite is true, and policymakers fear deflation. The Fed argues that its second round of quantitative easing or QE2, when it purchased $600 billion in Treasury bonds, averted the risk of such a downward spiral of falling prices and wages, which can take years to overcome. That’s why the latest figures from the Thomson Michigan survey of consumer sentiment may strike a chord, particularly with the Fed’s more dovish camp. Inflation expectations one-year out dipped to 3.2 percent from 3.3 percent. Even more strikingly, 5-years out, consumers’ inflation projection fell to 2.7 percent from 2.9 percent. That was the lowest in a year and just 0.1 percentage point above the mid-crisis low of 2.6 percent. Central bank officials also like to look at market-based measures, which derive investors’ expectations of inflation from the spread between regular bonds and ones that guarantee protection against inflation. Those readings have also been coming down, prompting Fed Chairman Ben Bernanke to respond to a question from an economics student in Cleveland last month with the following comment: It is something that we’re going to be watching very carefully. If inflation falls too low or inflation expectations fall too low, that would be something we have to respond to because we do not want deflation.  

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