Fed should heed market view of deflation risk: Minneapolis Fed chief

The chance of U.S. inflation falling below 1 percent in 2015 is at a five-year high, and the risk of deflation is growing more likely, an analysis of market data released by the Minneapolis Federal Reserve Bank showed.

Federal Reserve policymakers should take such changing market expectations into account when they make policy decisions, Minneapolis Fed President Narayana Kocherlakota and several of the bank's top economists said in a paper published on Tuesday.

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"An increase in the market-based probability of an outcome such as deflation could indicate that households consider it as more likely, or it could indicate that the costs associated with deflation have risen," the authors said. "Both of these changes should matter for a policymaker."

Narayana Kocherlakota, President of the Federal Reserve Bank of Minneapolis
Brian Snyder | Reuters

The Fed earlier this month effectively took the opposite view, downplaying falling market-based measures of future inflation and laying the groundwork for raising interest rates next year.

Kocherlakota dissented, arguing that the Fed should respond more forcefully to a weakening inflation outlook. The paper published Tuesday provides some of the theoretical backdrop for that view. Inflation has averaged 1.5 percent for the past several years.

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In an analysis also published on the Minneapolis Fed website, researchers analyzed options pricing and found that the market probability for inflation falling below 1 percent for the next year stands at 72 percent, a five-year high.

The chance of deflation, meanwhile, has risen to a "meaningful" 29 percent, according to the analysis.

The Fed targets 2-percent inflation, a goal it has not met in several years, and Fed officials say the recent decline in oil prices will put further downward pressure on inflation next year.