Last Friday as I was watching the capitulation in inflation markets to levels not seen since 2008, I was staring at my Bloomberg terminal gasping for a ray of hope and there it was – a headline just flashed across my screen ‘University of Michigan survey of inflation expectations increased from 2.8% to 2.9% for the year ahead and the 5-10yr inflation expectations rebounded from 2.6% to 2.9%’. Wow…compare that to the marked based inflation expectations (TIPS breakevens) which are almost zero for the 1yr ahead and around 2% for 5y5y forward. Even after accounting for the effects of the recent drop in energy prices, the disconnect between the market and the survey based inflation expectations seemed staggering.
This brought up the obvious question – what kind of response should we expect from the Fed? Which inflation measure would be the most relevant to them? Fortunately, we didn’t have to wait too long – the Fed statement yesterday shed light on their thinking about this.
In the last October’s FOMC statement, the Committee had noted that “survey-based measures of longer-term inflation expectations have remained stable” and glossed over the market based expectations as transient. At that time, it made sense as the catalyst for the decline was primarily technical. But now the drop in inflation expectations has happened amidst a larger backdrop of slowing global growth, huge decline in oil/energy commodity prices and increasing global economic weakness.
The market had increasingly started to expect a dovish tilt from the Fed and they didn’t disappoint. While the sport of slicing and dicing and analyzing every word of the Fed statement may go into full swing now, the bottom line is that it was seen as dovish enough and the market reaction was favorable. They would not want to choke growth or inflation and they will be reasonable and balanced about it as the data evolves.
Yesterday was an important day for inflation – both CPI and FOMC within hours of each other. The November CPI continued to show the themes we’ve been observing for a while – strong Shelter and Core Services partially offset by the weakness in Core Goods and drop in Energy prices. But as important as this CPI was to the market, it seemed like the star of the show, CPI, took a backseat to the director of the show, the Fed.
Taking a longer term view, the US is a large, service-based economy and most of the US inflation is domestically generated. The longer dated inflation (expected or realized) should not have a strong correlation to a sudden shock in oil prices unless it is expected to persist for a long time. So if the domestic growth remains on track, especially the strength in the labor markets and the corresponding wage growth, it shouldn’t be long before higher inflation risk premium gets priced into the market – or at least that’s one of my (many) New Year’s wishes.
Abbreviations: Fed: US Federal Reserve, FOMC: Federal Open Market Committee, TIPS: Treasury Inflation-Protected Securities, CPI: Consumer Price Index