Concerns about deflation from obscure source

SOMETHING unusual is happening to prices in the US right now: they are falling. The recent sharp decline in petrol prices is part of the story, but there is now growing fear that the Federal Reserve will undershoot its own 2 per cent inflation target, hindering the economic recovery. There's also a small but worrying risk that the US economy could enter a deflationary rut.

At issue are inflation expectations. Economists believe expectations are critical because they shape the decisions that individual shopkeepers make when deciding whether and by how much to raise their prices. Beliefs about inflation create a self-fulfilling prophecy in which today's expected inflation becomes tomorrow's actual inflation. The trick to managing inflation then is to manage inflation expectations. In practice, though, it is very hard to observe what people expect inflation to be.

That's why it's worth paying close attention to the disturbing portents from a relatively young and obscure derivatives market that provides new perspectives on inflation expectations - tracking not only the likely level of inflation, but also the risks that inflation might be too high, too low or just right.