World Economy

Fed Warned of Disinflationary Quagmire

Fed Warned of Disinflationary QuagmireFed Warned of Disinflationary Quagmire

The bond market is sending a warning to the Federal Reserve: a false step could leave the US bogged down in a disinflationary quagmire well into the next decade, Bloomberg reported.

The Fed has pumped almost $4 trillion into the financial system through debt purchases and kept interest rates near zero for seven years to help push price gains toward its 2% target. Yet break-even rates–the gap between fixed-rate and inflation-indexed treasuries–suggest investors see a growing risk policy makers will drive prices in the other direction if they start raising interest rates next month.

US government debt is “priced for inflation never to pick up,” said Michael Pond, head of global inflation-linked research in New York at Barclays Plc, one of 22 primary dealers that trade with the Fed. “The market is implying that tightening will be a policy error.”

The decline in break-even rates to levels at or below those reached in January–before the European Central Bank began $1.1 trillion of its own bond purchases and China devalued its currency–is even more alarming given that global policy makers now have fewer tools at their disposal to boost prices.

“If they had little to work with in the past, they have virtually nothing to work with now,” said Gregory Whiteley, a money manager at Los Angeles-based DoubleLine Capital LP, which oversees $76 billion.

The drop in inflation expectations has accelerated since the Fed’s July meeting, where policy makers appeared intent on raising interest rates before year-end.

Two-year treasury breakevens fell to within a quarter-percentage point of zero Thursday. What’s more, expectations for inflation in Germany have fallen to 0.37% percent over the next five years, while in the UK they’ve tumbled to 2.25%, down 0.44% percentage point from just three months earlier.

In the options market, traders are also wagering that inflation will cool. They’re paying the most since July 2012 for two years of protection against declining US prices. Oil fell as low as $40.65 Friday, headed for the longest run of weekly declines in almost three decades.