Thursday, March 31, 2011

Fed expectations update

This chart shows the market's expectation of where the Fed funds rate will be in one year's time. The one-year forward funds rate is expected to be 50 bps, which equates to approximately one very modest "tightening" of monetary policy (the funds rate target is currently 25 bps). Thus, no matter what you may hear people saying about what the Fed is expected to do over the next year, the current market consensus is one tiny move up in short-term interest rates sometime around February or March of next year.

Now, for things to actually turn out that way, I would argue that the economy is going to have to prove very sluggish, growing at no more than a 3.5% rate, and inflation is going to have to stop rising. Last year the economy grew 2.8%, and few forecasters are predicting a significant pickup (I think we could see 4%). Meanwhile, on a 3-mo. annualized basis, all measures of inflation have turned up meaningfully: the CPI is 5.6%, up from a low of -13.1%; the core CPI is 1.8%, up from a low of -0.2%; the PCE deflator is 4.0%, up from a low of -8.6%; and the core PCE deflator (the Fed's preferred measure) is 1.4%, up from a low of 0.2%.

Fed governors are not exactly unanimous in their opinion of the need to continue with QE2. Some argue that QE2 should be suspended next month, while others feel comfortable running QE2 through June as previously announced. What happens will be largely driven by the numbers. If inflation continues to pick up, the hawks are going to become more numerous and vocal, even if the economy doesn't pick up. Given the weakness of the dollar (at or near all-time lows in both nominal and real terms against a broad basket of currencies) and the strength of commodities (with most trading at all-time highs and up sharply in the past two years), I will be very surprised if inflation does not continue to heat up.

Finally, even if the Fed does raise rates sooner than is currently expected (something I expect), I doubt that this will be bad news for the equity markets. It would almost certainly be disruptive for the Treasury market, since rates out to 10 years are largely driven by the expected future path of the Fed funds rate. And it could cause corporate bond investors to get a case of the willies, though not a serious one, because spreads are still wide and it would take a whole lot of tightening to threaten the economy. It would be very positive for the dollar, whose weakness reflects a debilitating loss of confidence on the part of investors worldwide, because a Fed tightening even in the face of a modestly growing economy would show that once again the Fed has its priorities correct. Without a strong dollar, economic growth potential can quickly be frittered away on speculation, inflation, and asset market bubbles.

In short, an early tightening move would on balance be very good news in my opinion, and a welcome event indeed.


Public Library said...

The Fed is embarking on inflation and financial repression. This is similar to Japan and China in many ways.

If you cannot outright default, punish the people and the savers for as long as possible to save the banks and corporations.

It kicks the can down the road but does not solve the issues via tough + shared burdening.

Benjamin Cole said...

Short-term swings in reported inflation rates don't mean much. Long-term, we are seeing inflation well below the 2 percent target rate, and even that rate is low for the present. I would like to see us run a little hotter, in the 3 to 4 percent range for a couple of years or even longer.

We are still seeing declines (as of 4th q.) in unit labor costs and real estate is mushy-soft. Businesses are simply not facing inflationary pressures, despite some well-choreographed whining.

It is thrilling to see the private-sector so alertly responding to higher demands in the mining and manufacturing sector. The current trade-enhancing value of the dollar is helping exports, while high oil prices and some wonderful new technology is boosting mining. We will get gluts soon, driving prices back down--one of the oldest stories in commerce, btw.

The Fed needs to pout it on, perhaps for years. It is a new era, in which zero bound and capital gluts are persistent. The experience in Japan is that QE worked (even John Taylor gushed about the results) but has to be maintained.

Why stop QE at all?

As usual, I wish we would seize this opportunity to try to get a greater share of our GDP into the private sector, and shrink the public sector. I see little hope of that, given that the two parties are aligned deeply entrenched spending patterns.

Example: We now spend $147 billion a year in VA and veterans benefits. Who will cut that?

Public Library said...

I don't know where you live Ben but my gas is now 4.35/gal and the local shops are raising their food prices. See the quote below from the Walmart CEO.

"U.S. consumers face "serious" inflation in the months ahead for clothing, food and other products, the head of Wal-Mart's U.S. operations warned Wednesday."

This will get ugly for sure and the average American is going to suffer mightily. This is the stuff revolutions are seeded with.

Benjamin Cole said...

Public Library-

Gasoline and food have gone up, but both will likely moderate and perhaps drift down a bit from here. Clothes are cheaper than ever--ever shop at Ross Dress for Less?

The story you don't hear is the young couple buying a house for 40 percent off from three years ago, or the declining labor costs for American companies.

Why doesn't Wal-mart talk about unit labor costs?

Here in Los Angeles, office space is a complete steal, and much cheaper than three years ago, while factory space is cheaper too.

Those are stories too, they just don't get the headlines.

I keep hearing about inflation, but all we get is some motion in some commodities, and even those commodities are not really tied to monetary policy. Wheat shortages in Russia, or Libya meltdowns are not something Bernanke has much to do with. Corn is up on our rural subsidy-ethanol program.

John said...


Are you calling for one?

Benjamin Cole said...

Public Library-

Instead of revolting, Americans are planning to up output.

Corn is King as Farmers Chase Prices
Wall Street Journal - Scott Kilman - ‎1 hour ago‎
US farmers are responding to high crop prices by planning significant increases in plantings of corn, wheat and cotton this spring, the US Agriculture Department said Thursday.

Now, that's the kind of revolution I like!!!


Bernanke: please pour it on, baby, pour it on. Output is going up!

Lori said...

unsifyinHistorically, people in the US revolt when their tax rates go up. Not when random commodity prices spike for reasons that Benjamin has succinctly pointed out.

Unknown said...

FED is changing its rhetoric indeed.
Take a look on last Philly Fed President Charles Plosser speech followed shorthly by St. Louis Fed President James Bullard. They are clearly preparing markets for the beginning of the tightening cycle.