Selasa, 17 Juli 2012

The Fed has no reason to ease further

This morning, markets were a little disappointed that Fed Chairman Bernanke failed to pledge more monetary ease, despite increasing evidence that economic growth has slowed in recent months. As I see it, there is no reason for the Fed to do anything, so Bernanke did the right thing. There is nothing wrong with inflation or inflation expectations, so there is no need for the Fed to do anything different at this point.

June Consumer Price Inflation came in as expected. Although the headline number has fallen at a 0.8% annualized pace in the past three months, the core CPI continues to register inflation that is comfortably at or above the upper end of the Fed's target. The chart above shows the 6-mo. annualized pace of core inflation, and also highlights the times when the Fed began to undertake a significant quantitative easing policy. Clearly, a substantial decline in core inflation encouraged the Fed to act, in an effort to forestall deflation, which has been Bernanke's Public Enemy #1 for years. With core inflation now running at a 2.4% pace over the past six months, the threat of deflation is nonexistent, so there is no reason for further monetary ease. And as my earlier posts today noted, the housing market is continuing to improve and industrial production continues to expand. Where's the problem that warrants still more expansive monetary policy?

This next chart shows the nominal yield on 5-yr Treasuries, the real yield on 5-yr TIPS, and the difference between the two, which is the market's expectation for the average annual gain in the CPI over the next 5 years (i.e., "break-even inflation"). Note that near-term inflation expectations by this measure have been fluctuating between 1.5% and 2.5% for the past 30 months, with the current number being 1.8%. This is consistent with the view that the market expects the headline CPI to pick up over the next year or so, and that is particularly likely now that energy prices have stopped declining.

The chart above shows the Fed's preferred measure of inflation expectations: the 5-yr, 5-yr forward break-even inflation rate. The preceding chart shows that the market expects inflation to average 1.8% from mid-2012 through mid-2017, and the chart above shows that the market expects inflation to average 2.6% from mid-2017 to mid-2022. Again, no sign of any deflation threat here, and every reason to think that inflation will be on target, so no need for the Fed to do anything.

TIPS spreads such as I've posted here are important and reliable gauges to market inflation expectations, and they are rationally linked to the facts on the ground. They deserve attention.

If nominal Treasury yields were artificially depressed, because they are the object of global investors' affection and the object of the Fed's quantitative easing efforts, then the spread between TIPS and Treasuries should be artificially depressed as well. But on the contrary, we see that the spread (the break-even inflation rate) is behaving quite normally; the market has bid up TIPS prices in line with rising Treasury prices. That is very important, since it means that the decline in both real and nominal yields is not driven by declining inflation expectations, but by declining growth expectations. Once again, we see that current conditions do not point to any need for the Fed to take further action. Today's problems are not about inflation or monetary policy, they are about growth, and monetary policy has no power to conjure growth out of thin air as long as there exists no risk of deflation.

This next chart confirms this, since it shows that real yields on TIPS have declined in line with the slowing growth of the U.S. economy. As I see it, the current level of 5-yr TIPS yields is saying that the market is expecting real growth in the U.S. over the next few years to be close to zero. If we do indeed experience zero growth in coming years, then there will be lots of companies that are struggling to survive, and that will pose real problems for equities and corporate bonds. In order to avoid likely losses, investors are willing to sacrifice 1.2% of their future purchasing power (which is what a real yield of -1.2% on 5-yr TIPS implies) in order to enjoy the no-default-risk safety of TIPS. That is rational.

The future growth of the U.S. economy is now in the hands of our politicians in Washington, who need to remove barriers to growth, reduce the size and scope of government, and reform the tax code by broadening the tax base and keeping tax rates as low and as flat as possible.

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