Fed Watch: Tales from the TIPS

Should we be worried that the Fed is worried about our worries about inflation?:

Tales from the TIPS, by Tim Duy: Sure, the Fed cares about inflation….but enough to do anything about it? If inflation did begin to edge up, does anyone believe the Fed would bring its current easing campaign to a dramatic halt, especially given the fragile state of credit markets? Or a rapid reversal of recent policy? I think the answer is no, the Fed is not likely to change policy on the basis of yesterday’s data. Their forecast for inflation would have to rise markedly, but that's unlikely if the Fed has downgraded its near term output forecast as widely expected.

I myself am less complacent about the inflation forecast.  Two pieces of data arrived last week that were a bit disconcerting. First, Dean Baker directs us to the steep rise in import prices, up 1.7% in January, and a still impressive 0.6% after stripping out inflation. True, imports only account for roughly 17% of GDP. But I wonder if that misleads us as to the magnitude of the potential overall impact. Domestic producers have been in direct competition with foreign producers for decades. This competition has forced domestic producers to keep a lid on prices pressures. Rising prices for imported goods alleviates some of the pressure, giving home firms the opportunity to raise prices as well. 

Also last week the University of Michigan consumer confidence headline number plunged sharply, triggering another recession alarm. Less noticed in the report was the jump in near term inflation expectations. From the Wall Street Journal’s Sudeep Reddy:

Adding to the woes: Consumers’ expectations of inflation over the next year jumped to 3.7% (the highest since mid-2006) from 3.4% previously in the University of Michigan survey. Long-term expectations were unchanged at 3%, however, and market-based expectations of inflation remain relatively stable. But as calls for a Federal Reserve rate cut grow louder, any signs of rising inflation expectations could spook officials who are increasingly worried about rising prices.

Three thoughts. First, the high read on inflation raises the possibility of a surprise in this week’s CPI release. Perhaps consumers are picking up on something that the data will soon capture as well. Second, we saw the “Fed officials are worried about inflation story” on January 4 from Greg Ip in the Wall Street Journal:

The real disconnect is over inflation. The Fed thinks it is a bigger risk than it was in 2001, and bigger than Wall Street and many prominent economists think. That forces the Fed to accept a greater risk of recession than it did in 2001. That could mean either fewer rate cuts than anticipated by futures markets, which see the Fed's short-term rate target falling to 3% by year-end from 4.25% now, or a quicker reversal of the rate cuts.

The Fed delivered the 3% number by the end of January. So much for inflation fears. Don’t bother talking about the Fed’s inflation fears; we are well past that. As I said last time, I sense the Fed would like to stand pat in March, but I just can’t believe they will do it, and neither do market participants. If the Fed wants to reestablish control, they need at a minimum to hold their ground in March. Of course, that alone would raise the ire of the US Senate….

Finally, I was somewhat surprised to see Reddy suggest that market-based expectations are benign, not even mentioning his colleague Greg Ip’s post regarding higher expectations from January 31 (see knzn’s response here). I also note that the Cleveland Fed’s estimates of inflation expectations are at the high end of comfortable:

Charted are inflation expectations since the September 18, 2007 rate cut.  Also, for comparison, I added the inflation expectations that followed the beginning of the last easing cycle.  Expectations were lower in 2001, but jumped upward on February 8 of that year due to an increase in the estimated liquidity premium.

Is there any real difference between then and now?

In 2001, expectations stabilized around 2.5%, while, after the same 121 days, inflation expectations are still rising and now stand above the 3% mark at a level last seen in 2004, just before the Fed began raising rates that June. One interpretation is that expectations rose roughly 50-70bp since the Fed began easing last autumn when they should be going down, or at least holding around 2.5%, given the ominous forecasts for the US economy.

Is this meaningful? Should any of us get too worked up about 50bp? Inflation “optimists” will argue that expectations will quickly fall as the US recession gains steam. Inflation pessimists, however, will argue that 50bp is a reflection of real inflationary pressures that are global in nature and only likely to worsen given the Fed’s easy policy stance. Moreover, it is a gateway drug to the harder stuff – in no time at all, the Fed’s upper-limit will be 3%, then 4%, etc. Supporters of Fed Chairman Ben Bernanke will claim the Fed would quickly react to such a shift in expectations; detractors will claim he as already given too much ground, and with the financial markets suffering another potential setback with the troubled monoline insurers, he will have to yield even more in the months ahead. 

For my part, I think it is somewhat ominous if inflation expectations have risen to where they were before the last Fed tightening cycle – I don’t see a Fed policy reversal in sight. And incoming global inflation news is not particularly encouraging either. See Bloomberg’s dual story on the impact of Fed policy in Asia as nations are under growing pressure to revalue their currencies and implementing prices controls to tame inflation. Copper prices are up as stockpiles dwindle. Iron-ore suppliers are forcing consumers to accept huge price increases. And finally, even if you do not believe that we are seeing a meaningful increase in inflation expectations, the data still runs counter to the notion that the next big policy challenge is deflation.

In short:  I am not feeling at ease with the inflation outlook; a collapse in commodity prices would ease my concerns. A wholesale abandonment of dollar pegs across the world would heighten my concerns. The Fed appears to be betting on the standard hand – a US slowdown will ease inflationary pressures. It may take months to vindicate the Fed, and if they turn out to be wrong, they will be left with some truly difficult policy choices by the end of this year.

[Note: Tim mentions import prices. See Menzie Chinn's post on that topic, "Trade, Exchange Rates and Pass Through."]

Comments

[Bruce Wilder]

If we all agree that, even if the Fed does not adopt a particular inflation target, the Fed, nevertheless, intends to maintain a positive inflation rate, the only other question is whether some particular positive inflation rate is better than another in particular circumstances.

That the real, relative cost of commodities, such as copper, is rising must have some relation to monetary inflation. But, I don't know that I am clear on what that relation may be.

If the Fed were in the habit of targeting inflation rates, then a simple summary of recent Fed policy might focus on the Fed's willingness to target a somewhat higher inflation rate, as a way of coping with other problems and risks.

And, what are the costs and risks of a somewhat higher rate of inflation? Primarily, that the Fed will feel duty-bound to reduce that rate of inflation by inducing recession, which recession will probably coincide with the 2012 Presidential election -- a clear indication of the value of the Fed's political independence.

[esb]

Tim:

You have attained a complete clarity of understanding of this "mess."

In Asia, the UK and Europe investment bankers and central bankers are also agast at the collosal stupidity of central banking as practiced in the USA.

Investment bankers and conventional bankers in the USA are also agast, but most of us have our tin cups extended. "Alms for the love of Jesus?"

'cept over at GS, where the entire show is being choreographed.

[reason]

There is always a problem with "inflation" what does it really mean. I think the US is in for a period of falling real incomes (real wealth has already started falling dramatically). This will probably take the form of inflation. No inflation must mean falling nominal wages. The consequences in a country with large debts would be a catastrophe. Inflation simply has to rise.

[Jay]

Reason: I know humans can be quite myopic organisms and quickly forget the past, but if you were to lend money to an institution in their controlled currency and they decided rather than paying you back the full amount in real assets decided to inflate the currency, so that your returns were substantially less, would you ever lend them money again in their controlled currency?

Inflating the currency to payoff debts is a great short term play, but at what future costs?

[reason]

Jay,
I think the Dollar's days as a reserve currency are numbered come what may. And the answer to your question is, as it often with me, it depends who specifically you are talking about. There will be winners and losers no matter which decision you make, and in a democracy (at least in a proper democracy) it is the number of winners or losers that count not the size of their respective stakes that count. And always remember the famous Keynes quote, which is particularly pertinant here.

[knzn]

Essentially all of the major movements in the red series on that chart have been due to changes in the estimated liquidity premium. The actual TIPS spread has been surprisingly stable. So the argument about rising inflation expectations relies on having confidence in the Cleveland Fed's method for estimating the liquidity premium (as well as the assumption that the risk premium for inflation uncertainty is approximately constant over time).

I'm rather skeptical about that method. It relies specifically on the spread between on-the-run and off-the-run treasury securities, which is one among many possible measures of the premium on liquidity. It hasn't been following, for example, the TED spread (treasury vs. eurodollars), another popular measure of liquidity, which has fallen considerably in the past six weeks. I suspect that the method is having problems due to the fact that there are few earlier data points that resemble the past 6 months. It is trying to extrapolate from the more limited experience of the 10 years prior to last August. Also I think the data fit misses the fact that TIPS became gradually more liquid over the course of the years after they were introduced, and it is attributing part of this effect to changes in the premium for liquidity (as measured by on-the-run vs. off-the-run treasuries) rather than changes in the actual liquidity.

[hammerhead]

Paulson wanted a firmer Chinese currency. Paulson wanted imported goods to cost more so that Americans would buy less, and, thus, improve the US account balance. Mission accomplished. The American wage earner will suffer.

[Mike]

The U.S. is facing a major deflationary headwind. As assets prices fall in a period of over-leverage, you run the risk of a depression or at least a Japan-style slowdown. The Fed won't risk that. Reason has it right. Inflation is the name of the game and it's all good.

[Jay]

"it is the number of winners or losers that count not the size of their respective stakes that count"

By that measurement shouldn't we tax everyone in the U.S., Europe, etc. 80% and send the proceeds to Africa?

[Winslow R.]

TD wrote:"If inflation did begin to edge up, does anyone believe the Fed would bring its current easing campaign to a dramatic halt, especially given the fragile state of credit markets? Or a rapid reversal of recent policy? I think the answer is no."

I'd say yes is real possiblity.

The main issue with the current economic situation, is the ability of the financial system to function, not the 'real economy' which seems to be doing fine. People that default on their home loans can pick themselves up and brush themselves off as long as jobs are available. Banks are having a much tougher time.

Bernanke should admit banks are where his concern lies.

The 'big' surprise may be no more Fed cuts are needed to save the broad economy. Long term rates are increasing, indicating a large shift from debt purchases to goods and services purchases by foreign entities.

The fear of default lies with banks. Banks will likely be recapitalized either by foreign cb's or by last resort our domestic cb.

Where else might money come from?

Debt defaults by corporations are at cycle lows, corporations can afford to pay higher interest. Higher exports of goods and services will support this ability.

This call may be early, but perhaps CB's around the world have gotten the message, step up and stop buying debt. Allow long term rates to rise or lose all those reserves through inflation(instead of just part).

[Winslow R.]

Today, we are choosing the path of the 70's not the path of Japan, a good thing with Bush in office.

Tomorrow, we may change course. But today...

[esb]

Winslow R.:

Regarding your comment on corporate debt defaults, take a look at BB paper spreads right now.

WOW!!!

Something wicked this way commeth.

And soon.

[Winslow R.]

"WOW!!!

Something wicked this way commeth."

Are they 'wicked' is the question.

Are the spreads increasing due to lower purchases by foreign entities? My quess is 'yes' and then the increase in spreads is not 'wicked' but rather a 'gift' to the U.S. financial sector of wider spreads and therefore more profits.

If corporate defaults increase substantially, then it is indeed 'wicked'.

[Estimated]

The latest CPI is 4.2%, and the estimated future rate is only a bit over 3%? Something is wrong here.

[im1dc]

Professor Thoma asks "Should we be worried that the Fed is worried about our worries about inflation?"

Answer: No, we need to worry about the $50 Billion US money center banks had to borrow last week in the dark of the night.

[Winslow R.]

"Answer: No, we need to worry about the $50 Billion US money center banks had to borrow last week in the dark of the night"

The $50 billion was not borrowed by the money center banks. It is borrowing by depository institutions going around the money center bank 'monopoly' through the TAF.

[im1dc]

Winslow R., corrects me: "The $50 billion was not borrowed by the money center banks. It is borrowing by depository institutions going around the money center bank 'monopoly' through the TAF."

Thanks for the correction.

However, with that correction now I'm even more concerned since it was the big money center banks that stupidly bought the mortgage securities, not the smaller local banks that were supposed to be solvent and able to continue to lend, at least locally.

Is that breaking glass and crushed metal I hear in the distance?

[john jansen]

The 10 year TIP spread had a chunky move in trading on Tuesday as the break even moved about 5 basis points to 233 basis points from 228 basis points. That is the sector that ifollow and I suspect that would hold true for other points along the yield curve.
If I return to the 10 year TIP its price action today showed it outperforming nearly everything else in high grade fixed income land on a relative basis. So it outperformed the 10year Treasury as well as swaps ,mortgages and agencies.It is only a one day move but impressive nonetheless
JJJ

[calmo]

The general turf according to TimIf inflation did begin to edge up, does anyone believe the Fed would bring its current easing campaign to a dramatic halt, especially given the fragile state of credit markets? Or a rapid reversal of recent policy? I think the answer is no...Imagine the guffaws if the Fed decided to tighten...as the homeowners get set to party with their not-so-tight $600.
Imagine if consumers were on the verge of breaking out and demanding wage increases on the order of oil price increases...contrast that with GM looking for illegal aliens to work cheap.
Not sure if this is too kind or whether I'm missin it:
The Fed appears to be betting on the standard hand – a US slowdown will ease inflationary pressures (not in evidence with this week's iron ore prices, oil prices, food prices and alternative life styles for GM workers, those wages going south, yes?). It may take months to vindicate the Fed (the strapped consumer was eventually able to find cheaper money, just not mortgages yet?), and if they turn out to be wrong (not cutting fast enough?), they will be left with some truly difficult policy choices by the end of this year. Another couple of 50bp and an unscheduled 75bp or 2 will just about leave the Fed with no bullets...which is a variation on the theme 'All hat no cattle'.
So I'm sure we haven't seen the last of the $600 rebates, in a continuing effort to avoid that predicament, you?

[im1dc]

What's wrong with this picture?

But first, let me point out that Macklowe borrowed the money to buy this building and is selling it b/c his note is due and he doesn't have the money to pay it off.

I assume the two parties offering $3B today are also borrowing the money.

New York's GM building could fetch a record price

February 20, 2008

"The General Motors Building in midtown Manhattan, New York had at least two bidders offering $3 billion or more for the 50-story tower near Central Park that is home to the FAO Schwarz toy store and Apple's Fifth Avenue outlet."

"The current owner, Macklowe, bought the building from the insurance firm Conseco for $1.4 billion in 2003."

Reconstruct link:

http://www.newsday.

com/news/local/wire

/newyork/ny-bc-ny--generalmotorsbuil

0220feb20,0,2008811

.story

Things sure look good for Manhattan RE. But why?

A paper profit of $1.6 B in 4 years sounds to me like another bubble needs popping.

[im1dc]

Shamelessly lifted in toto from Brad Delong's blog Comments from February 20, 2008
"Marty Feldstein on the Current Macroeconomic Situation": (this guy "Neal" seems knowledgeable, preceptive and clever to me)

"Comments

Col. Jessep: You want answers?
Kaffee: I think I'm entitled.
Col. Jessep: You want answers?
Kaffee: I want the truth.
Col. Jessep: You can't handle the truth.
+++++++++++++++++++++++++++++++++++++++

"Pretty much the state of affairs in the banking world today. Disclosure and markdowns would severely damage a significant portion of the banking and investment world. I doubt that would restore anyones confidence in the system. Right now, the public perception of the problem is that there were too many houses bought with shakey borrowers and shady lenders are the problem--not the vast amount of money invented in the mortgage securitization process. So incremental dripping of losses and bad news will continue, in hopes that a magical cure will be invented next week.

"There are no heroes that will willingly walk in front of the guns with a bared chest--there are only people hoping to keep their paycheck, bennies and bonuses for another few months.

Posted by: Neal | February 21, 2008 at 06:55 AM

im1dc asks: What the heck are auction rate securities aka ARS and why are they important? See:

"From Bloomberg, today:

(quote)

"Hundreds of auctions (for auction rate securities) have failed this month, sending borrowing costs as high as 20 percent because dealers from Goldman Sachs Group Inc. to Citigroup Inc., UBS AG and Merrill Lynch & Co. stopped using their own capital to support the sales.....are now watching a $342 billion market evaporate at the expense of taxpayers.

"Inadequate disclosure ``may have masked the impact of broker-dealer bidding on rates and liquidity,'' Martha Haines, head of the Securities and Exchange Commission's municipal office, said in an interview. ``The large numbers of recent auction failures, which are reported to have occurred due to a reduction in bidding by broker-dealers, appears to indicate those concerns were well founded."....

""The banks were the backstop," said Sharon Binnun, the chief financial officer of Citizens. "If you had more sell orders than buy orders, they'd pick up the difference and you wouldn't have a failed auction."

"Officials at Goldman, Citigroup, UBS and Merrill declined to comment. All the firms are based in New York, except UBS, which is located in Zurich. UBS told its brokers this month that it won't buy bonds that fail to attract enough bidders, and Merrill said it was reducing its purchases.

"Auction-rate securities are long-term bonds whose interest resets every seven, 28 or 35 days at bidding run by a dealer who collects a fee of about 25 basis points. Unlike Treasuries or stocks, there is no daily source of information about auction- rate bonds. Issuers have relied on banks to be buyers of last resort when bidders couldn't be found at their auctions.

(end quote)

"A liquidity issue or a solvency issue? Do they have the reserves anymore to devote to a profitably rigged market that they have run for years?

"Posted by: Neal | February 21, 2008 at 07:59 AM"

Thank you Neal.