Objects In Mirror May Be Closer Than They Appear
The Fed delivered QE4, as expected, on Wednesday as it pledged to continue buying longer-dated Treasuries even though it will no longer sell shorter-dated Treasuries in Operation Twist. In other words, they will accelerate the balance sheet expansion from $40bln (all mortgages) to $85bln (Treasuries and mortgages) per month, beginning next month.
What was unexpected was that the FOMC decided to parameterize the “soft Evans rule” that has been in place since the summer but which has grown gradually more specific since then. The relevant passage from the statement was this:
“In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”
The financial chatterverse immediately set about guessing how quickly the economy could reach 6.5% unemployment, and variously asserting that this was a hawkish or a dovish statement based on their assessment of the likelihood of reaching that level soon. (According to the Fed’s projections, released somewhat after the FOMC statement, they expect to reach that level sometime in 2015.)
But that isn’t the binding parameter. As I showed yesterday, longer-term inflation expectations are arguably not very well-contained; moreover, 1 year inflation, 1 year forward is currently around 2.15% in inflation swaps. Inflation swaps are based on CPI, not PCE, so this equates to roughly 1.90% in forward PCE versus a 2.50% barrier for the Fed. As the chart below shows, 1y inflation 1y forward hasn’t been above 2.75% in a while (equivalent to 2.50% on PCE), but it has gotten pretty close in recent years. It doesn’t seem like a bad level to target, but it’s much closer than the market seems to understand.
Here also is 5y, 5y forward, but from inflation swaps rather than breakevens (source: Bloomberg). The Fed prefers breakevens, because they imply a lower level of inflation; market participants know (at least, most of them know) that this is due to quantitative phenomena that distort Treasury yields low and that the inflation swaps market typically gives a better indication. Note that the upward trend I identified in yesterday’s column is still there, although somewhat less monotonic.
Street economists in the immediate aftermath of the FOMC announcement made lots of pronouncements but in generally were looking at the wrong thing. I saw economists look at the 10y spot BEI at 2.4% when the 5y, 5y forward inflation swap – more relevant to examining is around 3.20%. This is wrong. The right numbers to look at are now 1y, 1y forward and 5y, 5y forward.
The Fed in this statement is no less dovish than they had been. They are led by a super-dove and Lacker still dissented as the lone voting hawk. But the Committee is increasingly painting themselves into a corner as they have parameterized the Evans Rule. They’ve drawn a line in the sand now, and when inflation bursts higher and 1y1y is trading at 3.5%, it’s going to be hard for the Fed to keep forecasting 2% for next year with any credibility. In his press conference, Chairman Bernanke listed as indicators the Fed will look at on the inflation side: median and trimmed mean CPI, the views of outside forecasters, and econometric models of inflation. He didn’t mention market prices at all! So, we can expect that the Fed will try to ignore (as they are already ignoring) market indicators of inflation expectations…but at some point, this will become more or less untenable.
On the fiscal cliff front, there was again no progress. JPM Chairman Jamie Dimon said on CNBC that the economy will boom if the fiscal cliff is averted: the same unsubstantiated assertion that the President and members of Congress have been making recently.
Here is my question: isn’t it in a booming economy that we’re supposed to reduce the deficit? If the economy is really as strong as they say it is, then the fiscal cliff is timely. I mean, if we increase the deficit in recessions and don’t reduce it in booms…do you have to be able to do much math to see where that leads? Even a CEO who mistook a big punt for a hedge ought to be able to do THAT much math.
So all the good news is out, unless the fiscal cliff is averted. I suspect the stock market will slide from here, and interest rates will rise into year-end. With volumes this low, that’s a perilous call to be sure, but in my mind the risks outweigh the rewards of betting the Santa Claus rally will continue.