WASHINGTON | Tue Nov 2, 2010 2:06pm EDT
WASHINGTON (Reuters) - Early strides in the battle against deflation could make Ben Bernanke's Federal Reserve a victim of its own success.
The Fed has already sparked a pick up in bond yields and inflation expectations just by laying the groundwork for a new bond buying program.
Those very gains could thwart the consensus for a larger -- and potentially more effective -- second round of purchases.
"The Fed has succeeded in lifting expectations of inflation and that has actually reduced the risk we'll get deflation," said Michael Moran, chief economist at Daiwa in New York.
"But they still have to go through with it. They have to ratify the expectation that's been built into the market."
In laying out the rationale for a new monetary stimulus effort, Bernanke emphasized the risks posed by uncomfortably low inflation, phrasing the argument in terms even the Fed's more hawkish members can get behind.
However, this sort of specificity has its downsides. In anticipation of another installment of Fed bond buys expected to total at least $500 billion, the market's implied inflation premium has been drifting higher, pushing up prices of global stocks and commodities in its wake.
The underlying inflation trend also appears to have stabilized, albeit at levels considered too low for some at the Fed. The central bank's preferred core inflation measure rose just 1.2 percent in the year through September, down from 1.3 percent in August but hardly in deflationary territory.
"We haven't seen an acceleration in the decline, so the risk of a very near term disinflationary environment seems to have subsided," said Ian Lyngen, senior government bond strategist at CRT Capital Group in Stamford, Connecticut.
DEFLATED RISKS
Estimates from the Atlanta Federal Reserve Bank suggest the risk of deflation has receded from about 27 percent in late September to around 22 percent today. A recent study from the San Francisco Fed was even more sanguine, indicating only about a 5 percent risk of an outright drop in average prices throughout the economy from now through 2013.
That's great news of course, and should give Fed officials increased confidence about their ability to support a flagging economy going into a two-day meeting that will end with a keenly awaited decision on Wednesday.
Indeed, refuting the notion that the Fed is out of ammunition, St. Louis Fed President James Bullard has repeatedly pointed to moves in financial markets in anticipation of further easing as a clear sign that policy can in fact work even with official rates near zero.
In one particularly striking example, the Treasury last week issued inflation-protected securities with a negative yield for the first time ever. That suggested investors are anticipating enough inflation in the future to be willing to pay the government for that protection today.
The gap between nominal five-year Treasury yields and those on inflation-linked notes of the same maturity has widened to about 1.65 percent from as low as 1.25 percent in August.
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