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Tuesday, February 19, 2008

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."]

    Posted by on Tuesday, February 19, 2008 at 12:34 AM in Economics, Fed Watch, Inflation, Monetary Policy | Permalink  TrackBack (0)  Comments (21)


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