Fed Watch: Data Supportive of Fed Plans

Tim Duy:

Data Supportive of Fed Plans, by Tim Duy: Incoming data in the second half of this week continues to support the Federal Reserve's plans to begin normalizing policy in the middle of next year, with the removal of "considerable time" language next week a likely first step.

Retail sales for November were unquestionably strong and reveal an acceleration in the pace of core sales:

You were right if you dismissed the early earnings on the holiday shopping season as useless noise. Similarly, consumer confidence is pushing to pre-recession levels:

And note this from Reuters:

"Expected wage gains rose to their highest level since 2008, and consumers voiced the most favorable buying attitudes in several decades," survey director Richard Curtin said in a statement.

As I have said before, nothing interesting happens until we get unemployment below 6%. Be prepared for a better equilibrium.

Even as the economic data improve, however, Wall Street remains on edge. Lower oil prices and the resulting impact on high yield bonds are resonating throughout credits markets while equity prices struggle. Despite warnings from Fed officials about the likely path of policy, long-dated US Treasury yields continue to remain under pressure. It is difficult to assess the impact on policy-making at this point. Fed officials will be torn between the market turmoil and expectations that lower energy prices will boost an already accelerating economy. And note that New York Federal Reserve President William Dudley was very dismissive of the idea that the Fed would respond to every financial market disruption as policy moved toward normalization:

Because financial market conditions affect economic activity only slowly over time, this suggests that we should look through short-term volatility and movements in financial markets. We should not respond until we become convinced that the movements will likely, without action on our part, prove sufficiently persistent to conflict with achievement of our objectives. Often, financial markets can be quite volatile and move a lot without disturbing underlying economic performance.

Similarly, he has been dismissive of market-based measures of inflation expectations.

In assessing inflation expectations, I currently put more weight on survey-based measures of inflation expectations as opposed to market-based measures. Survey-based measures have been generally stable, consistent with inflation expectations remaining well-anchored. However, market-based measures, such as those based on breakeven inflation derived from the difference between yields on nominal versus Treasury Inflation-Protected Securities (TIPS), have registered declines over the past few months, even on a 5-years forward basis. Research done by my staff suggests that much of this decline in market-based measures of inflation compensation reflects a fall in the inflation risk premium—that is, what investors are willing to pay to protect themselves against inflation risk. Adjusting for the fall in the inflation risk premium, inflation expectations appear to have declined much less than implied by TIPS inflation breakeven measures.

Market participants believe the Fed leans heavily on the 5-year, 5-year forward inflation metric. That measure is heading toward lows last seen on the eve of operation twist:

The Fed dares not defy this chart. Or do they? Jim O'Sullivan at HFE accurately notes that the 5-year, 5-year forward breakeven has been inordinately driven by oil prices:

Why Fed prefers "survey based:" 5y5yf TIPS swing with oil even tho current infl irrelevant for pic.twitter.com/StxfsvubNh

— Jim O'Sullivan (@osullivanEcon) December 12, 2014

The Fed may be losing faith in these measures. As Dudley suggests, they may feel that such metrics are too simplistic, and find themselves favoring metrics like that offered by the Cleveland Fed that shows a firming of inflation expectations in recent months:

Note also that the resilience of survey-based metrics of inflation expectations. Back to Reuters and the confidence report:

The survey's one-year inflation expectation rose to 2.9 percent from 2.8 percent, while its five-year inflation outlook also rose to 2.9 percent from 2.6 percent last month.

And that leads me to my bottom line - another question for Federal Reserve Chair Janet Yellen at next week's post-FOMC press conference.

Bottom Line: I would like a journalist to press Yellen on her interpretation of the 5-year, 5-year forward breakeven measure of inflation expectations. Does she see this measure as important or too noisy to be used as a policy metric? What is her preferred metric?