One of the key aspects of the Fed’s policy framework is that inflation doesn’t need to accelerate in order for the FOMC to start the normalization process. Instead, the Committee has explained that it only needs to be “reasonably confident” that inflation will return to 2% to feel comfortable raising rates. This has confounded many investors, as the FOMC appears to be taking a leap of faith that its policies will generate inflation at some point in the future, even though there isn’t much evidence of it right now. Justifiably, many people are wondering what the harm is in waiting to see some inflation before pulling the trigger on tightening policy. In fact, one market appears to be pleading with the Fed to reconsider its preemption; market-based measures of inflation expectations derived from TIPS are historically low.
The Fed’s rationale has been that monetary policy works with a lag, and with unemployment falling rapidly, they need to act now in order to head off future inflationary pressures. The Committee has also expressed the opinion that inflation is transitorily low as a result of the dual shocks of a stronger dollar and lower energy prices. Furthermore, the FOMC doesn’t appear to put much faith in the collective view of the TIPS market, as it has disregarded the low level of breakevens as a red herring. In fact, the Committee shrewdly refers to breakevens as inflation “compensation” not “expectations”. It’s a subtle distinction, but one that could have significant ramifications, as the FOMC is willing to overlook distress signals emanating from this market. To be fair, the FOMC’s dismissal of breakevens isn’t completely without merit, as the sector has shown a tendency to react acutely to commodity markets and global risk sentiment, as opposed to domestic CPI fundamentals. That said, TIPS breakevens haven’t recovered to the levels that predated the oil sell-off, despite the fact that the extreme downward momentum in energy markets has abated.
In aiming to snuff out inflation or other financial imbalances before they occur, the FOMC is relying on macroeconomic models that depend on historical relationships between resource utilization and inflation. As the story goes, accommodative monetary policy sparks economic activity, which reduces excess capacity, which pushes up the price of labor, goods and services. This is generally how the world has worked in the past, but what if past performance is not indicative of future results? What if the Fed isn’t measuring slack accurately or if it’s making incorrect assumptions about how low unemployment needs to be in order for inflation to rise? Markets have asked these questions, and appear to have come to the tentative conclusion that the FOMC is putting too much faith in its models or too little faith in the TIPS market.
This is evident by looking at the inflation swaps market, which is telling us that inflation won’t reach the Fed’s 2% goal until 2025, and will only average 1.5% over the next ten years. Meanwhile, the Fed thinks that it will achieve 2% inflation as early as 2018. Embedded deeper within this market is a probability distribution that highlights a range of inflation outcomes that investors think will occur in the future. If the FOMC is looking at this, it should be worried, as the market is assigning a 12% chance that inflation will average 0% or lower over the next ten years and a 30% chance that it will average 1% or lower.
In a recent speech, FOMC Chair Yellen argued that one of the main benefits that have accrued to the Fed after years of careful and credible monetary policy is the stability of inflation expectations, without which it becomes very difficult to conduct effective policy. This realization should give the FOMC pause before it overlooks the message that markets are sending.