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Fed’s Bond-Buying Wild Card

Many investors have lowered their expectations for future inflation, a shift that could get the attention of Federal Reserve officials as they consider the course of their bond-buying program at a policy meeting next week.
The Fed has a 2% inflation goal and doesn’t want consumer prices to veer too much above or too much below that number over time. Some recent inflation measures have dropped below that level this year, but Fed officials haven’t been too worried because expectations of future inflation were stable.
Now that expectations show signs of shifting, too, Fed officials could feel pressed to rethink their view that consumer prices will return to their target. If the fall in inflation expectations persisted and deepened, it could cause some Fed officials to argue for continuing their bond-buying program at the current $85 billion-a-month pace for longer than otherwise.
“It is no longer clear that inflation expectations are so stable,” Jan Hatzius, chief economist at Goldman Sachs Group Inc., said in an interview. Market-based measures of inflation expectations are now on “the low side of comfortable.” In a note to clients June 10, he predicted that expectations of lower inflation are likely to make Fed officials less willing to pull back on the bond-buying programs out of fear it could destabilize those expectations about future inflation.
Fed officials are now in their self-imposed premeeting blackout period in which they don’t speak publicly. Their public comments before this period have largely suggested they aren’t deeply concerned about inflation getting too low.
Expectations matter so much to Fed officials because they believe businesses and households act today based on what they expect for the future. If they expect consumer prices to fall a lot in the future, they might cut back on spending today.
In that context, the Fed launched its bond-buying program to bolster economic growth by pushing down long-term interest rates and pushing up asset prices, hoping that would spur spending, hiring and investment. If officials believe the economy is on track to gain strength in coming months, they might start to reduce the size of the bond purchases. But if they thought low inflation and falling expectations signaled new weakness in the economy, they might want to continue the program at its current level for longer.
Analysts will be looking to see if the Fed makes any changes to its formal policy statement at the end of next week’s meeting that reflect the softening expectations, or if Fed Chairman Ben Bernanke addresses them during his news conference after the two-day meeting concludes Wednesday.
After its May 1 meeting, the Fed said while inflation “has been running somewhat below” its 2% target, “[l]onger-term inflation expectations continue to remain well anchored.”
One closely watched indicator of market inflation expectations shows how expectations are softening. The so-called breakeven rate—or the difference between yields of conventional Treasury securities and Treasury Inflation-Protected Securities—widens when investors expect higher inflation and narrows when they believe inflation is headed lower. TIPS pay investors a return adjusted for changes in the consumer-price index.
In recent weeks, the gap has narrowed: It shows investors’ expect inflation in five years to be 2.459% as of Tuesday, down from the 2.7% they expected at the end of April and the nearly 2.9% expected at the beginning of the year, according to Fed data.
To be sure, despite these drops, inflation expectations by this and other measures remain above the Fed’s 2% inflation target, which is one reason the Fed may not be too worried.
But if investors’ expectations of future inflation continue to fall it could become a growing issue for Fed officials. They became worried about expectations softening too much in 2010 when these measures were near 2.2%, and responded by launching a second round of bond buying.
The latest shifts in expectations are happening against a backdrop of sharp declines in measures of actual inflation. The Labor Department reported Thursday that prices paid for U.S. exports of consumer goods, excluding autos, fell 1.3% over the last year, the biggest drop since the agency started keeping track in 1983. Prices of goods imported into the U.S. also fell.
The Fed’s preferred inflation gauge, the Commerce Department’s price index for personal-consumption expenditures, has come in well below 2% recently. In April, the latest month for which there are data, it was up just 0.7% from a year ago, and the “core” index—which strips out volatile food and energy costs—was just 1.1% higher than a year earlier.
On an unrounded basis, the April core reading—1.05%—was at the lowest level ever recorded in the history of the index, which goes back to 1959.
Minutes of Fed officials’ May 1 meeting show they are keeping a close eye on inflation. “A number of participants expressed concern that inflation was below the Committee’s target and stressed that future price developments bore careful watching,” the minutes said.
There are some obvious benefits to falling inflation. Lower energy and food prices mean consumers have more money to spend on other things. In general, though, the Fed tries to keep inflation stable near 2%, a level that central-bank officials believe supports steady economic growth and hiring. Big moves either above or below that make it hard for businesses and households to plan for the future.
“Keeping inflation expectations anchored at levels consistent with the central bank’s medium-term inflation objective—2% on the personal consumption expenditures deflator in our case—is vitally important,” New York Fed President William Dudley said in a recent speech reflecting on lessons learned from Japan’s experience with deflation, or falling prices. “Once deflation expectations become well entrenched, it is very difficult to change them. And, because inflationary expectations are an important driver of actual inflation outcomes, deflationary expectations can be self-fulfilling in driving actual deflation outcomes.”
Jon Hilsenrath contributed to this article.
Write to Victoria McGrane at victoria.mcgrane@wsj.com

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