Intentional Ignorance?

By: Michael Ashton | Wed, Jan 25, 2012
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I want to state clearly at the outset that no one at the Fed was compensated in any way by me or my company for their words and deeds of today. While I am grateful at their gracious underwriting of the inflation biz, I neither expected it nor provoked it nor, to be honest, welcome the effects it will have on the overall economy.

The Fed is clearly the story of the day, in a way it really hasn't been for quite a while. I think the consensus was that the "new communications policy" of the Fed was likely to be a near-term fizzle even if it provided long-term fireworks. But instead, the Fed made some fairly dramatic statements (albeit couched in code) about the way monetary policy will be conducted going forward. In retrospect, perhaps they wanted to make a big splash today so that attention would be drawn to the importance of the new communications regime; if it had caused nary a ripple (and it would have been easy to make it cause nary a ripple) then it would have belied the importance of the new regime.

The Fed released its normal statement at the conclusion of deliberations; the new component that was added was the release of a table of projections from the Fed Governors and regional Fed Presidents (both voting and non-voting) detailing their expectations for the likely paths of growth, inflation, unemployment, and the Fed funds rate for the next couple of years and for the long-term. The Fed released both the 'central tendency' (the range when you throw out a few highs and lows) and the actual point estimates themselves although not associated with the names of the contributors.

The first surprise of the day was that the Fed extended the projection of the period of exceptionally low rates from "at least mid-2013" to "at least late 2014." Considering that recent data have shown a stabilizing of growth, this was a surprise. Moreover, the Fed removed completely from the statement the phrase "However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations." The message was crystal clear: the Fed is willing to be actively inattentive to the inflation risks so as to allow themselves to keep rates lower for longer and potentially to add more liquidity.

Bonds jumped on the news, but inflation-linked bonds jumped more (after a few hapless souls initially hit bids for some reason). Commodities rallied sharply, from down slightly on the day to +1.1% on the DJ-UBS commodity index. Crude Oil turned positive after having been negative. Gold rallied. Industrial metals leapt. Stocks, too, rallied with the S&P up 0.9% at the close.

The release of the poll of Fed meeting participants, a couple of hours later (I am not sure I understand the delay, if the point is to help communication), muddied the waters a little bit because it showed that at least several Fed officials expected a rise in the Fed funds rate in 2014. If rates are to stay at 0.25% until "at least" late 2014, this makes no sense; ergo, at least some of the discussants figure that the "at least" isn't definitive and depends on the state of the economy. Also, some discussants may have felt that "extremely low" rates could include an 0.75% Fed funds rate, which was not the market's understanding of that phrase. But as Julia Coronado of BNP pointed out, those who favor earlier and more aggressive rate hikes "are not the drivers of monetary policy and their views can therefore be set aside." I agree.

The other forecasts are interesting as well. Of the 17 members recording votes, not one expected less than 2.1% growth in real GDP this year. Not one expected the Unemployment Rate this year to tick up more than 0.1%. Not one expected core PCE inflation (currently at 1.7%) to exceed 2.0% in 2012, 2013, or 2014. The message is very clear: the Fed considers inflation to be no risk at all - or at least, they want us to think that's what they think.

Here is my question: if no respondent forecasts a recession, or even very slow growth, on the horizon, then they cannot be considering that a recession will be restraining inflation even if they are using discredited Keynesian-based models. But they're also forecasting continued extremely low interest rates, so they cannot be thinking that tight monetary policy will be restraining inflation. And yet, the central tendency expectation is for declining core inflation, or at worst only a slight rise in core inflation. How can this be? Here are the possibilities I can think of:

  1. The Fed plans to actually tighten policy by selling assets, even if they keep rates down. I think this is pretty unlikely.
  2. The Fed thinks that "anchored expectations" will hold down inflation. This is possible, and the Fed believes strongly in the idea that expectations anchor actual inflation even though the evidence for that proposition is "sparse" to be charitable.
  3. The Fed thinks that money velocity will fall, and doesn't plan to respond by adding more liquidity. I doubt this is the case, although if you believe there is a natural deleveraging process going on you might make this argument.
  4. The Fed thinks housing prices will fall and therefore it is a smart bet to forecast falling core inflation even if they expect most prices to rise. This is sneaky, but possible, although I would find striking the irony of their confidence in forecasting housing price declines now when they couldn't forecast them 30% higher.
  5. The Fed is trying to manipulate expectations. This is very likely. Bernanke said in his press conference that the Fed's main tools now are "communications and asset purchases." I don't know how communications can be a "tool" of monetary policy, if you're just telling the market what it already knows; if you're telling the market something it doesn't already know, it's only valuable if on balance you're better at forecasting than the market and that is decidedly not the case with the Fed.

The final possibility is that the Fed fully intends for prices to rise and inflation to accelerate, but seeks to define the mission (or leave it undefined) in such a way that they can argue they are being "credible" in sticking to the plan even though the results would prove it was the wrong plan. When the Fed first introduced the "mid-2013" shackles I suggested that could be one possible reason for intentionally limiting their options. By "lashing themselves to the mast," they need not respond to the sirens telling them to hike rates and restrain inflation.

In addition to the statement and the table of projections, Bernanke also had his press conference. He commented that expanding the Fed's balance sheet "remains an option" and said "we're not absolutists" when it comes to inflation. That's an incredible statement. It wasn't so many years ago when Federal Reserve dogma was that employment is maximized in the long run when inflation is kept low and stable, so that the Fed was pursuing both maximum employment and low inflation if they just pursued the inflation goal. Now, Bernanke is saying very loudly that they can let inflation go a little higher, a little lower, as needed to address other economic imbalances. This sounds very much like BOE Governor Mervyn King's comments yesterday in which he converted the 2% "target" rate into, effectively, a floor (be sure to read yesterday's comment "A Funny Thing Happened On The Way To Deflation" if you haven't, as there are some very good charts in it).

Core inflation is in an upward trend around the world, and it has been so for nearly two years. With this backdrop, and a strengthening domestic economy, the Fed is extending its low-rate pledge and talking about doing more asset purchases because the economy and, especially, housing is so weak. Meanwhile, although I don't necessarily take this at face value, the FHFA's Home Price Index rose 1.0% month/month in November (data released today), the largest 1-month jump since 2005. Here is a question to ponder: does merely stabilizing home prices help the economy, since just as many mortgages will be under water if prices stay flat? There are three ways to solve the mortgage crisis. One is to distribute the losses from homeowners who have them now to taxpayers or to mortgage bond holders through defaults. One way is to jazz homeowner incomes so much that they can pay these losses (which become realized when they change residences and sell at a loss). The third way is to force nominal home prices up so that the losses go away. There is only one of these three that the Fed can do anything about.

The 10y Treasury today ended below 2% because the Fed declared it would keep on going with Operation Twist. But Twist has a natural limit in that once all of the short-maturity bonds are sold from the Fed's portfolio, they can't buy longer-duration bonds except outright. I would not depend on Fed purchases to protect my 2% yield. Unless growth collapses, I don't think these low bond yields can be sustained. I am short bonds through the TBF ETF, and would add more if I didn't think long commodity index exposure just got a lot more attractive today.

On Thursday, there's a fair amount of data due. The December Chicago Fed Index (Consensus: -0.10 from -0.37), December Durable Goods Orders (Consensus: +2.0%/+0.9% ex-transportation), and Initial Claims (Consensus: 370k from 352k) are at 8:30ET. The first two should be supportive of equities; Initial Claims is still in the crap-shoot time of year and doesn't mean much. New Home Sales (Consensus: 321k from 315k) is at 10:00ET, and the Money Supply figures will be released at 4:30ET.



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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