What Were You Expecting?

By: Michael Ashton | Wed, Jun 22, 2011
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The Federal Reserve today did almost exactly what its members have been telegraphing they would do for a long time: nothing. As QE2 winds down as planned, some observers were assuming that QE3 would be right on its heels. But over and over during the past few months, Fed officials have shown much more concern about the exit, and about the potential for future inflation, than they have shown about the tepid pace of growth. This is appropriate, since monetary policy has very little effect on growth (although there are plenty of people, including people at the Fed, who believe that it does despite the experiment just completed) and mainly works to raise the price level.

In August, the Fed had every reason to pursue quantitative easing. The two elements of the Fed's mandate - sustainable growth and stable prices - usually suggest opposite policies; late last year, however, with core inflation too low and growth also weak, both mandates argued for more stimulus. Even if the Fed only cared about averting the risk of deflation, it would have been defensible to institute the LSAP (large-scale asset purchase program). However, this is no longer true. The variable that the Fed can affect most directly, the price level or rate of inflation, is rising and core inflation is near the level the Fed considers neutral and the lags inherent in monetary stimulus imply that policy will still be pushing prices higher for some time. Growth is weak, but $600bln didn't change that and there is no reason to think that another $600bln would - but even if there was a reason to think so, the tradeoff is now more difficult.

Perhaps surprisingly, the Committee seems to realize that and the Chairman said as much in his post-meeting coffee talk.

This surprised a lot of observers, evidently, as did his suggestion that the failure of Greece would bring instability and threaten the European system. You don't say? You know, I don't think he should be speaking so bluntly about it either, but I have consistently said the Fed could better pursue its function if it kept its mouth shut. Some of the people who seem surprised are the folks who wanted the Chairman to hold these conferences in the first place. Look, if you hand the microphone to Andrew Dice Clay you shouldn't be shocked at what comes out. Extemporaneous speaking is a great medium for comedy, but an awful one for policy-making. We are very lucky that he said nothing sillier than that the "securities purchases were successful" in fighting deflation, which is a hard argument to make seriously when core inflation - ex-housing - bottomed in late 2003 (see Chart).

2003 bottoming in core ex-housing
I ran this last week, but this time focus on the bottoming in core ex-housing...in 2003. That was well before QEx.

Neither bonds nor equities cared much for the not-as-dovish (it is hard to call it 'hawkish' when there is no hint of a tightening in the future) meeting result. Bonds ended up roughly flat at 3% on the 10y note (10y TIPS up to 0.77% real) but stocks fell 0.7%.

Modest pressure on TIPS came from two fronts today. The first was from a very poorly-reported article entitled "Change To Inflation Measurement On Table As Part Of Budget Talks - Aides." The article noted said that "Lawmakers are considering changing how the Consumer Price Index is calculated, a move that could save perhaps $220 billion and represent significant progress in the ongoing federal debt ceiling and deficit reduction talks."

For those who aren't aware of it, Congress doesn't calculate the CPI. Moreover, Congress has really nothing to say about how the CPI is calculated; the Bureau of Labor Statistics is part of the Administrative branch. The best that Congress could do is threaten to de-fund the entire BLS if it didn't calculate CPI the way that Congress wanted. But this isn't a Constitutional crisis. It is bad reporting. What Congress is considering is whether to use a different CPI index, incorporating chain-weighting methods that would tend to reduce the tendency of the CPI to overestimate inflation in one very technical way. The BLS already calculates such an index, called the Chained CPI-U, and it is readily available on the BLS website.

Congress also does not set the terms of the bonds that are issued by the U.S. government. Those terms are set by the Treasury, which is a department of the Administrative branch, and moreover they are governed by a bond indenture. While I can imagine a circumstance where the Treasury would simply change the rules on which TIPS would pay out, changing to follow a different index in violation of the bond indenture would probably constitute a default. They're not going to do that to save a few tenths of a percent on 7% of their outstanding debt.

So here is what this change, if it happens, will not do: it will not affect how TIPS are paid. It will not affect monetary policy (since the Fed focuses on the PCE deflator anyway). It will not affect the inflation swaps market, which will continue to track the same index that TIPS do until there is more creativity on Wall Street.

What it will do is to transfer wealth from young Americans to old Americans. It would seem that the effect would go the other way, wouldn't it, since it will affect the future benefits of the retired? True, but it will affect the future benefits of the non-retired by much, much more. (You didn't really need to know that; you could simply have observed that older people vote more than younger people and you would know which way the money is likely to flow).

So whatever distress was caused among holders of TIPS today by this report can be blamed on bad reporting. Move along, there's nothing to see here.

TIPS also experienced a little bit of pressure from the fact that there is a TIPS bond auction tomorrow. The Treasury will sell $7bln more of the current TIPS long bond, bringing to $16bln the total outstanding in that issue. Selling $7bln of the Feb 41s at a real yield of 1.84%, when the Fed is done buying, will be challenging. Ordinarily, long TIPS auctions go reasonably well or at least clean upreasonably well because inflation is a long-wave problem. If you need inflation protection, you most likely don't need it for 5 years but for 10, 20, or 30 years (and for years, I have been arguing that some company should issue an inflation-linked perpetual bond or the government an inflation-linked 'consul'). At 1.84%, or a little higher, the auction will probably be a little sloppy but passable because while these yields are low by 30-year TIPS standards (see Chart, source Bloomberg), that real yield compares reasonably favorably with other investments available right now. For example, stocks are priced to deliver a real yield around 2.1% over the next ten years.

Real yields of 30y TIPS are very low by historical standards.

Also tomorrow, although less-exciting for my tastes, we'll get Initial Claims (Consensus: 415k vs 414k last), the Chicago Fed National Activity Index (Consensus: -0.05 vs -0.45), and New Home Sales (Consensus: 310k vs 323k). Expect equities' performance to remain muted and for bonds to also struggle to do much positive until the market has come to grips with the -unsurprising - end to QE2.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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