Inflation Expectations and the Fed's Next Move

We are getting a number of conflicting signals about important risk factors in the economy. Some signals are up and some are down, painting a particularly confusing picture. Unemployment figure (U3) is down to 9.0%, even though the economy does not seem to be generating a lot of jobs. Much of the decline in unemployment seems to be due to the fact that some people are so discouraged that they are not even looking for a job. Housing starts are stuck in the 500,000 range for over two years, and they are still down about 50% from the peak. In contrast, GDP has been growing fairly robustly, most recently about 3.2%. Most recent survey of 55 economists revealed that that GDP growth will further increase to about 3.5% by year end. Stock market is doing very well. Market has erased most of the losses from the financial crisis and the S&P 500 earnings are expected to hit record levels in 2011, surpassing its 2008 peak. Yet, in his testimony before Congress, Federal Reserve Chairman Ben Bernanke indicated that it is too early to reverse, shut down, or even slow down the monetary faucet, in spite of all of these improvements. He indicated that there is no current inflation and some of the inflation concerns are overblown. Fed also says that it is vigilant and it is ready to pull out liquidity if and when inflation rises. For his evidence, Bernanke pointed out the low 1.5% year-on-year CPI inflation, even though CPI can have genuine measurement problems with respect to exact nature of substitution effects and quality adjustments. Meanwhile, massive levels of monetary and fiscal stimuli continue. Federal Reserve is determined to continue with $600 billion purchase of 10-year T-Notes, even though it has brought its balance sheet assets to $2.5 trillion already a record. At this rate, Fed's balance sheet could hit $2.8 trillion by summertime. All in all, Fed's asset base has expanded by $1.7 trillion during the financial crisis. Fiscal stimulus also continues. Fiscal year 2012 budget deficit is likely to surpass $1.6 trillion. These developments are quite alarming to a lot of investors. Other indicators of inflation are also signaling alarm. While CPI inflation is low, gold is trading at near record levels, commodity prices, especially wheat, cotton, corn, soybeans are all up 50% to 100% in the last six months. This entire picture seems to be quite confusing to the average investor. Is there or is there not a threat of inflation? At what level of inflation will the Fed intervene and start cutting liquidity? This is quite the sixty-four dollar question. The fact the Ben Bernanke is reluctant at this time to even entertain the possibility of slowing down monetary faucet is also quite worrisome since it suggests the possibility that much of the recent improvements in the economy are due to massive monetary and fiscal stimuli. Absent the crutches, Bernanke seems to be worrying that the economy and the stock market can easily roll back. It is also becoming quite clear to a lot of investors that most of the bullets with respect to monetary and fiscal policy are already spent. It is quite unrealistic to expect that Federal Reserve can expand its balance sheet by another $1.7 trillion or for the Federal Government to continue with $1.7 trillion a year deficits. What will happen if monetary and fiscal stimuli are stopped? All of this makes inflation a key figure to pay attention to. Clearly, commodity prices and CPI are backward looking, noisy measures of historical inflation. They may or may not provide good guides to future inflation. We need a less noisy, forward looking inflation measure. A good forward-looking inflation measure is the difference in the yields of ten-year T-Notes and 10-year TIPS (Treasury Inflation Protected Securities). This is a market-based long-term inflation expectations figure. This forward-looking inflation expectation has averaged 2.06% for the entire year 2010, which is pretty close to Fed's tolerated range. For the last month and a half, the average daily inflation expectations inherent in the Treasuries have risen to 2.34%, with a most recent reading of 2.28% as of Monday, February 14 closing prices. Clearly, market participants are indicating that inflation expectations going forward are increasing. So far, the increase in inflation expectation in reaction to all the stimuli has been mild, thereby justifying the reluctance on the part of the Fed to act soon. There is no guarantee, however, that market expectations of inflation will not be jolted sometime in the future. In my view, it would be a good idea to focus on this inflation number as a potential guide to Federal Reserve‘s next move.