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Why, if everybody is wringing their hands on inflation, do market-based measures of expectations remain so low?

Morgan Stanley cite polling from their Global Credit Summit last week in Venice. Inflation was the number one macro concern of about a third of the crowd, while three quarters of those attending expected US headline inflation to average 3 per cent or higher over the next three years.

Yet the breakeven inflation rate on US TIPS over five years - the difference between the yield on nominal Treasuries and inflation-protected TIPS - is just 2.2 per cent.

The bank offers two explanations. Either investors trust that central banks will ensure that inflation stays in check over the longer term by taking appropriate action, or market-based market measures are distorted by crisis-induced buying of bonds. Their answer is a bit of both.

The relative sizes of the nominal and the inflation-linked market mean there’s a liquidity premium contained in the so-called breakeven rate - one which is likely to have increased during the crisis, say MS. The bank’s model for fair value of 10-year Treasuries shows a widening gulf between yield and fair value.

We attribute a large part of the widening gap between actual yields and fair value since the start of the credit crisis to safe-haven buying and the heightened demand for good collateral. If so, breakeven inflation rates are also depressed due to this factor and true inflation expectations in the bond market are likely to be higher than this indicator suggests. Once the credit crisis abates and the exceptional demand for government subsides, breakeven rates should thus rise, revealing higher true inflation expectations.

But Morgan Stanley also thinks that investors are putting too much faith in the central banks’ ability to control inflation. Global factors are no longer disinflationary and the targets date back to a time when globalisation, deregulation and strong productivity growth weighed down on inflation. Emerging market economies have become a source of inflation, the productivity boom has ebbed, and monetary policy has been expansionary for most of this decade.

Morgan Stanley’s bottom line:

Central banks are likely to keep missing their targets, and we expect the debate about raising the targets to pick up. Look for both true inflation expectations and breakeven inflation rates to rise over time.

Related links
Fed hints at pause as rates cut to 2% - FT.com