Drop in inflation expectations is becoming worrisome, Fed's Bullard says

The recent drop in oil prices is a net ‘positive’ for the US economy, as accelerating consumption up until mid-2015 showed, but the decline in market-based inflation expectations that has accompanied it “is becoming worrisome”, a top-ranking US central bank official said on Thursday.

Speaking from Memphis, Tennessee, the president of the Federal Reserve bank of St.Louis, James Bullard, explained to his audience that large movements in crude oil prices only have a short-lived impact on inflation, once they have stabilised, although they did mean inflation might take longer to return to target.

“The fall in crude oil prices to lower levels, even if maintained indefinitely, has only a one-time influence on the year-over-year inflation rate,” he said.

Thus, if oil prices fell to $20 per barrel and then flatten out at that level by June 2016, the consumer price index would not reach 2% until mid-2017, whereas if it had held at $40 in November – while the rest of CPI components continued rising at the same pace as up until that month - then CPI would reach 2% by the end of 2016, Bullard told his audience, according to the text of his speech.

However, in principle longer-term inflation expectations should not be impacted by such price movements, but this time around they were being “unduly influenced”.

“I have argued that market-based measures of inflation expectations have been unduly influenced by the large movements in crude oil prices,” Bullard said.

“Nevertheless, with renewed declines in crude oil prices in recent weeks, the associated decline in market-based inflation expectations measures is becoming worrisome.”

Low inflation expectations might keep actual inflation lower, all else equal, making it more difficult for the central bank to return CPI to target.

“Headline inflation will return to target once oil prices stabilize, but recent further declines in global oil prices are calling into question when such a stabilization may occur,” he said.

Bullard attributed the crash in oil prices from $105 per barrel in the summer of 2014 to around $30 at present "in part to increased supplies from new oil extraction methods that became economically feasible during the 2008-2014 price regime."

In a more nuanced tone, later in the day Reuters reported that Bullard had said that up until now he thought the slip in inflation expectations would be transitory, but now he was worried.

Bullard made no reference in his speech to the frequency of rate hikes he expected in 2016 (as per the official press release and presentation).

The outlook for four rate hikes still seems "about right," Bullard said, according to Reuters.

"Now we are 18 months into this and I am starting to wonder if my story is the right one [...] For me inflation expectations are a key factor and if they continue to decline I would put increasing weight on that," Reuters added.