Francesco Canepa & Balazs Koanyi

FRANKFURT, Reuters – While investors are pricing in some of the highest inflation rates for both the United States and Euro zone in recent decades, central bankers might be better advised to keep in mind the flaws that the indicator may contain.

Five-year/five year forward gauge of market inflation expectations, or 5y5y, has reached 2% in eurozone. Its counterpart in the United States is higher than that threshold. This is the goal of the Federal Reserve and the European Central Bank.

Should the central banks declare victory, and then raise interest rates?

It’s not happening so quick.

Flaws are found in both indicators that measure investors’ willingness to accept inflation risk for a 10-year period.

They have a bad track record in predicting inflation, but they can predict oil price movements and have uncanny correlations.

The economic logic is not applicable since the one measure refers to the cost of a barrel oil that will be delivered immediately and the other is an indicator of the long-term change in global prices.

This correlation could be due to the inner workings of financial markets where certain investors use inflation-linked products as hedges to other trades.

Is the 5y-5y a reliable predictor for future real inflation? I don’t think so because it correlates to oil futures, which are bad predictors,” said Ilia Bouchouev, a managing partner at Pentathlon Investments and a lecturer at New York University.

His company is one of the few hedge funds who seek to profit from this correlation. They trade both inflation swaps and oil futures simultaneously when prices diverge.

Additionally, due to the small trading volume of the European 5y5y swap contracts, only a few traders are able to influence its price. This can be further influenced by market volatility.

These limitations and others have been well known by the ECB since long.

Inflation swaps were warned against in 2006. It also concluded last year that market imperfections had caused a 30 basis point drop in the 5y5y’s since 2008, resulting in a fall of 100 basis points.

It was not better than the U.S. 5y5y. It is not based on the euro zone counterpart, but it does use the breakeven rate. This refers to the difference between the nominal yield and the inflation-linked Treasury bond yield.

Some investors believe that the 5y5y is losing its importance as an indicator, with the Federal Reserve holding almost 25% of the Treasury Inflation Protected Security Market (TIPS) and 55% of the underlying Treasuries.

Sonal Desai (chief investment officer at Franklin Templeton Fixed Income Group), stated in a podcast that “pricing on breaksevens to some degree is somewhat controlled”

(GRAPHIC: Oil price and the ECB’s favourite gauge of inflation expectations – https://fingfx.thomsonreuters.com/gfx/mkt/egvbkmrqdpq/euro%205y5y%20vs%20Brent.png)

ROD FOR OWN BACK

They have their backs made by central bankers.

Mario Draghi, the then President of the ECB, unleashed market obsession with the 5y5y in the euro zone. He elevated it to the top central bank’s preferred measure for inflation expectations. This speech opened the way for a huge bond-buying program.

This might have caused the 5y5y’s own death based on Goodhart’s law.

The law is named after Charles Goodhart, a British economist who was a former Bank of England policymaker. Marilyn Strathern later reformulated it. It states that a measure ceases to qualify as a good one when it becomes a goal.

Philip Lane, the chief economist at the ECB, and Isabel Schnabel, a board member, have begun to complement the 5y5y by incorporating the possibility, implied in option price prices, that inflation will be within specific ranges.

Politicians also spoke of old-fashioned predictions by flesh-and bones economists.

According to a Reuters poll euro zone inflation would be at 1.8% next years, 1.6% in 2023, 1.6% and 1.6% respectively in 2024. However, this is not enough to meet the condition that the ECB raises its interest rate. The condition is that the ECB sees price growth at 2%.

Fed for its part has also created the Index of Common Inflation Expectations which merges market prices with surveys.

Nonetheless, Christine Lagarde (ECB president) and Jerome Powell (Fed chair), regularly cite market expectations as evidence of their relevance.

Although surveys can be shielded from market turmoil, they have drawbacks like a small sample size or relative infrequency.

Fritzi Koehler Geib chief economist, German state bank KfW stated, “In all the end all indicators are limited so we follow the preponderanceof evidence.”