UBS: Pacific States of America

A novel from the 60s, called "The Man in the High Castle" recently became a successful TV series. In this novel's alternative reality we see the US split between Germany and Japan, with the west coast renamed the "Pacific States of America". It has been said that life imitates art, and at the moment it appears that markets are imitating art by pricing in a 'Japanification' of inflation in the developed world, particularly the US and Eurozone.

The market expectations for a 'Japanification' of these economies is clear from the developments in long term expectations in the Eurozone and the US; they resemble the correction that we saw in Japan when it entered the so-called lost decade (ten years of very weak growth and inflation close to zero). There are different measures of inflation expectations, with some being taken from consumer surveys and based on their expectations for future inflation. One problem with this approach is that consumer expectations tend to be influenced by current inflation. Inflation is meant to be also driven by inflation expectations, but the surveys look more like lagging than leading indicators.

For this reason, many central banks prefer a market-based measure of inflation expectations, the so called 5y5y inflation forwards. This measures financial markets' expectations for average inflation over the 5 years starting 5 years from now (i.e., inflation in years 5 to 10). And because it looks at inflation expectations in the future it should be more stable and not influenced by the short term fluctuations of oil or food prices. In general, market based inflation expectations tend to be higher than the central bank inflation target. This mainly reflects the term and liquidity premium (most inflation linked instruments are less liquid than sovereign bonds) and has nothing to do with central bank credibility.

Der komplette Bericht als pdf-Dokument.