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According to Bill Diviney, senior economist at ABN AMRO, against the backdrop of low inflation and elevated risks to the US growth outlook, market-based inflation expectations (5y5y forward breakeven) have declined considerably, from 2.1% as recently as April, to 1.8% in recent weeks.

Key Quotes

“A bigger concern is the decline in more stable survey-based measures, and in particular the  Michigan consumer survey. In June, 5-10y expectations fell to 2.2% – the lowest in  the survey’s 40 year history. While such a number might not seem like much to  worry about given the Fed’s target is 2%, as a survey-based measure this is likely  to be inconsistent with 2% realised inflation.”

“To illustrate, the last time core PCE inflation was at the Fed’s 2% target on a sustained basis was in 2008, when the Michigan survey-based measure averaged 3.1%. As such, a 2.2% reading from the Michigan survey likely corresponds with a core PCE rate below 2%.”

“It appears, then, that the prolonged period of subdued inflation is leading to  expectations becoming unanchored. At a time when the Fed is actively examining  policy framework changes that would raise inflation expectations, this  development should be particularly worrisome to FOMC members.”

“Expectations are hard to shift once they become entrenched, as they often feed into wage  expectations, creating a self-fulfilling dynamic. Indeed, Fed Chair Powell voiced  concern over the possible de-anchoring of expectations at the June FOMC press  conference, while more dovish members of the Committee such as James Bullard  and Neel Kashkari have explicitly cited the fall in inflation expectations as a reason  to cut rates.”