Rising Inflation Expectations Conflict With Fed Rate Cut

A story on Bloomberg notes that the Fed has been sanguine so far about inflation because inflation expectations haven’t seemed to be rising. However, a measure the Fed relies upon, the five year forward inflation rate, has risen above the level that led the Fed to start its rate increases in 2004. In other words, it is signaling that the Fed should be increasing, not lowering, Fed funds rates.

This development suggests that there is a possibilty, which is not reflected in Fed futures prices, that the Fed might stand pat at it FOMC meeting this week. Similarly, the OECD has also called on major central banks not to lower rates right now. But the Fed has seemed completely unwilling to disappoint traders, and I think the likelihood of a change in behavior is nil.

From Bloomberg:

The key to whether the Federal Reserve continues to cut interest rates after this week may hang on the wall behind economist Brian Sack’s desk in Washington.

Sack, head of monetary and financial market analysis at the Fed in 2003 and 2004, uses a chart that plots forward rates measuring investor expectations for inflation in five years. The gauge is so accurate that Sack and his colleagues persuaded the central bank to use it to help set policy. The chart is autographed by former Fed Chairman Alan Greenspan.

Right now, it shows current Fed Chairman Ben S. Bernanke may have less room to lower borrowing costs than investors in Treasuries anticipate, potentially setting bondholders up for a fall. The expected inflation rate, which Sack says replicates what Fed officials use, reached 2.91 percent last week, the highest since 2004, when the central bank began the first of an unprecedented 17 rate increases. The measure was at 2.79 percent on Nov. 1.

“One of the defining features of the Bernanke Fed to date is its emphasis on measures of longer-term inflation expectations,” said Sack, whose partners at Macroeconomic Advisors include former Fed Governor Laurence Meyer. “The Fed is willing to tolerate short-run movements in inflation, but only as long as those movements don’t appear to be dislodging long-run inflation expectations.”

Any evidence that accelerating inflation is becoming entrenched may heighten the Fed’s debate as policy makers consider cutting rates to keep the worst housing market in 16 years and mounting losses in securities related to subprime mortgages from tipping the economy into recession.

Futures on the Chicago Board of Trade show a 100 percent chance the Fed will lower its target for the overnight lending rate between banks by at least a quarter-percentage point to 4.25 percent, the third cut since September. The chances are at least 50 percent that the Fed will cut again at its next two meetings, on Jan. 30 and March 18, to as low as 3.5 percent.

The gauge used by Sack, dubbed the five-year five-year forward breakeven inflation rate, suggests bets on lower Fed funds rates may be too bold. The fact that the rate stayed steady for much of the past two months as pessimism about the economy grew bolsters that view, said Michael Pond, an interest- rate strategist in New York at Barclays Capital Inc., one of the 20 primary dealers of U.S. government securities that trade with the Fed. A cooling economy typically tempers inflation concerns.

“The market, by keeping the same inflation expectations while lowering growth expectations, is implying there are inflationary pressures,” Pond said. He held to that view even as the forward rate fell last week.

Bond investors are demanding about 1 percentage point more in yield to own Treasuries maturing in 10 years than due in two years to compensate for the risk that consumer prices will accelerate. There was no difference as recently as June.

Sack and other analysts derive the measure of inflation expectations from yields on five- and 10-year Treasury Inflation Protected Securities and Treasuries.

Five-year TIPS yield 2.15 percentage points less than five- year notes. This so-called breakeven rate is the average inflation rate investors expect over the next five years. The forward rate projects what the breakeven will be in five years, smoothing blips in inflation expectations from swings in oil prices or other events.

The five-year TIPS’ breakeven rate rose to a six-month high of 2.47 percent Nov. 27, the week after oil climbed to a record $99.29 a barrel, from about 1.9 percent on Aug. 31. As crude fell to a six-week low on Dec. 6, the breakeven rate declined and Sack’s measure dropped to 2.85 percent…..

The dollar, which is poised to depreciate against the euro for a second straight year, is also fueling inflation concerns. The currency’s drop and oil’s climb pushed import prices up 1.8 percent in October, the most in 17 months.