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Fed Fight to Lift Inflation Is Another Likely Victim of Virus

Fed Fight to Lift Inflation Is Another Likely Victim of Virus

(Bloomberg) -- Coronavirus may look like a textbook supply shock that would spur higher prices, but investors are betting inflation will go the other way -- and the Federal Reserve appears to agree.

Fed Chair Jerome Powell told reporters this week that the virus would weigh on economic activity for some time as he announced an emergency half-point interest-rate cut. Officials see the outbreak delivering a hit to demand and putting downward pressure on prices.

“For those that want to interpret this as a pure supply shock, they’ve got some explaining to do -- unless they are also willing to say inflation is going to go up, because that’s what a supply shock, as conventionally defined, would be doing,” St. Louis Fed President James Bullard said Wednesday in a Bloomberg TV interview.

Fed Fight to Lift Inflation Is Another Likely Victim of Virus

The economic logic behind the idea of a supply shock is that, for a given level of consumer and business demand for goods and services, a sudden reduction in their availability will put upward pressure on prices.

Kenneth Rogoff, a former International Monetary Fund chief economist, warned in a Guardian op-ed Tuesday that shutdowns in China could cause a global recession like those exacerbated by the oil shocks of the 1970s, where prices went up instead of down.

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“You’re going to have forces pushing different goods or services in opposite directions,” said Bob Miller, head of Americas fundamental fixed income at BlackRock in New York. “The airlines are going to be under a fair amount of pressure, yet mask prices and drug prices and other health care-related goods and services are likely to see upward pressure.”

“Factor-weighting those things is a near impossible task,” Miller said. “We’ve looked at it, and I don’t think it’s worth us spending days trying to forecast the proportional attribution of inflation components,” he said.

Financial market signals point to inflation heading down.

Break-even inflation rates in government bonds -- a proxy of the compensation investors demand to hedge against inflation risk -– have plummeted to the lowest levels since 2016. The rate cut, the largest since the 2008 financial crisis, hasn’t managed to lift them above those levels.

Impossible Task

U.S. central bankers have fretted for years about inflation running persistently below their 2% target, and the impact of the virus on demand will only push them to think harder about how best to put a floor under it.

For now, futures linked to the Fed’s benchmark overnight interest rate indicate investors expect at least another quarter-point reduction when policy makers gather in Washington for their next regularly-scheduled meeting on March 17-18.

Inflation Welcome

Counter-intuitively, in the seemingly unlikely event that prices rise because of constrained supplies from the virus outbreak, it would probably be welcomed.

“We have been trying to get inflation up toward target,” Bullard said. “So, I think if we got that kind of development -- I’m not really expecting that, but let’s suppose we got some bottlenecks and some pricing that was enough to drive inflation somewhat higher -- I think we’d welcome that and accept that.”

Fed officials watch break-even inflation rates closely because they’re one of the only ways to gauge investors’ inflation expectations in real time. Officials also put a lot of weight on inflation expectations because the economic models they use suggest expectations are an important determinant of actual inflation.

But it’s a little more complicated than that. When break-even inflation rates plunge, like they have in recent days, that could be the result of investors seeing less of a risk of higher inflation, as opposed to marking down their actual expectations, said Jon Hill, an interest-rate strategist at BMO Capital Markets in New York.

“The big risk is that a negative inflation risk premium becomes self-fulfilling,” Hill, a former New York Fed trader, said. “And that’s what the Fed is very afraid of.”

To contact the reporters on this story: Matthew Boesler in New York at mboesler1@bloomberg.net;Emily Barrett in New York at ebarrett25@bloomberg.net

To contact the editors responsible for this story: Margaret Collins at mcollins45@bloomberg.net, Alister Bull

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