Inflation Pause at the Fed's Pause

Over the past six months, we have warned that the market has consistently under-estimated the magnitude and duration of the Federal Reserve’s monetary tightening cycle. Unwaveringly we forecast Fed funds to be at least at 5.5% by the end of this year and we recognized upside risks to our scenario. We had thought that the Fed would pause in June and resume raising rates after the summer. We now see a June rate hike as likely and we would view such a hike as being in addition to the other hikes we had envisaged later this year. We expected the Fed funds target to be at least at 5.75% at the end of the year, with upside risks that carry into early next year.

Measured inflation is rising and several measures of inflation expectations are rising as well. Headline consumer prices thus far this year are rising at an annualized rate of over 5%, the worst start of a year since 1990. The core measure is up 2.3% from year ago levels. The pace of core CPI peaked in February 2005 at 2.4% and appears posed to move surpass it this summer, partly reflecting higher energy prices being passed through. The Fed’s preferred measure, the deflator of core personal consumption expenditures rose 2.0% year-over-year at the end of Q1. The April data will be released on May 26th and is expected to rise above upper end of the implicit target (“comfort zone”) of 2.0% for the first time since March 2005. The core measure peaked in November-December at 2.3% and the risk is clearly that this surpassed in the coming months.

Other measures of inflation also appear to be confirming increased pressure. These would include surveys, like the Philadelphia Fed’s prices paid index for manufacturers, which is at a 7-month high. Import prices surged in April to a 5.9% year-over-year rate after trending lower from almost 10% last September to 4.6% this past March. Average hourly earnings in April rose at a 3.8% year-over-year clip, the strongest rise since late 2001.

Yet to avoid confusion, we need to be clear: the Fed needs to and in fact does respond to inflation expectations, not simply recorded inflation. Inflation expectations are more difficult to measure, though going forward they deserve and will likely receive greater attention by market participants. The spread between conventional Treasuries and inflation protected securities (TIPS) has widened noticeably in recent weeks and early this month flirted with the 10-year spread widened to 275 bp level, near its historically widest (greatest inflation expectation). Of course, this spread reflects three elements: inflation, inflation expectations and a liquidity premium as the TIPS are not nearly as liquid as conventional Treasuries. In the past the Fed has cited the University of Michigan’s survey as well, but there are a number of short comings of such surveys, such as lack of availability in real time and some other methodological issues.

There are other developments that appear consistent with rising inflation fears. These would include the steepening of the US yield curve and arguably the broad based decline in the dollar’s value. The broad trade weighted measure of the dollar has fallen by about 7% since early March. Such a decline, should it be largely sustained, ioffsets some of the Fed’s tightening. There is not a hard and fast trade off, but generally speaking, given the role of the US external sector, the 7% depreciation of the trade-weighted dollar may be tantamount to around a 50 bp cut in rates.

Shades of 1987
Market participants often look for historical parallels. After the recent G7 meeting, the obvious parallel was the Dubai G7 meeting in the fall 2003 that called for greater flexibility for Asian currencies and helped fuel a 6-month decline in the dollar. The dollar fell persistently against the yen during that period even though it marked a period of unprecedented heavy dollar purchases by the Bank of Japan.

However, when considering US monetary policy, a comparison with 1987 may be more revealing. Recall that Alan Greenspan took the helm of the Fed from the retiring Paul Volcker. Volcker’s reputation as Chairman of the Federal Reserve was as a tough inflation fighter. At his first opportunity Greenspan hiked the Fed funds and discount rate in early September. Germany and Japan, fearful of their own inflation pressures, were threatening to raise rates further. US Treasury Secretary James Baker reportedly threatened to let the dollar fall if Germany (and Japan) raised rates and/or failed to boost domestic demand. This set the stage for Black Monday (October 19) when global equities melted down and the dollar sank like a brick.

Although Greenspan had Washington experience, in many ways he was an unknown quantity from investors’ perspective especially given the gravitas and respect Volcker had earned. The market had to test his mettle and would do so a number of times over his tenure.

Benjamin Bernanke finds himself in a similar position. Although Bernanke had previously been a Fed governor, succeeding Greenspan would be a challenge for anyone and Bernanke’s mettle is being tested. Some pundits argued that grown men, and especially those with Bernanke’s credentials, need not prove themselves. One commentator opined that boys playing in a sandbox need to prove themselves, a chairman of the Federal Reserve does not. We saw things differently.

In addition to economic analysis, we argued that insight from game theory would also argue in favor of a number of rate hikes early in Bernanke’s tenure. We do think talk of the Fed losing credibility is probably an exaggeration. A close reading of the record would indicate that Bernanke never indicated that the Fed would in fact pause in June, though it was clear that if the data was sufficiently in line with the Fed’s expectations, a pause was desired, if for no other reason that to see the impact of past hikes and to try to gain some strategic flexibility.

The market has repeatedly thought “one and done” when it comes to Fed moves this year. Many observers misunderstood Bernanke not because the Chairman misspoke or was purposely ambiguous like his predecessor. Rather the misunderstanding arose primarily because of the market’s pre-conceived ideas and biases. The appointment of Federal Reserve Governor Donald Kohn to be the vice chairman of the Federal Reserve will help reassure the market. Kohn was reportedly considered for the chairmanship itself. He has been at the Fed for more than 35 years and is more experienced at the Fed than the other governors combined. It is also noteworthy that Kohn is not in favor of a formal inflation target, which Bernanke has advocated. This signals Bernanke’s comfort with a collegiate approach does not require to be surrounded by those that agree with him.

We have tended to de-emphasize the role of external imbalances to explain or predict currency movement. Our emphasis has been on interest rates, differentials and the slope of the curve. However, we fear that just like after in the summer and fall of 1987 and after the Dubai G7 meeting in fall 2003, the G7/IMF have re-politicized the foreign exchange market. The additional rate hikes that we expect the Federal Reserve to deliver will in effect simply offset the easing impulse generated by the falling dollar. In addition, the European Central Bank is appearing more aggressive than we had thought as well. The Bank of England, which we had earlier thought could cut rates, now looks poised to hike in the coming period. Japan also appears poised to raise rates earlier and more aggressively than we thought likely at the start of the year. We view the current dollar rise as counter-trend and one that will provide a new opportunity to raise dollar hedges or reallocate funds away from the US. We have raised our year-end euro forecast to $1.33 and have reduced our dollar forecast to JPY106.
Inflation Pause at the Fed's Pause Inflation Pause at the Fed's Pause Reviewed by magonomics on May 19, 2006 Rating: 5
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