It started subtly, about a month ago, in the fed funds futures market, where investors had come to view Federal Reserve Chairman Ben Bernanke’s word as deed: first, the August pledge to hold the benchmark rate near zero until mid-2013; then, on Jan. 25, the extension of that target date to late 2014.
Investors priced fed funds futures contracts accordingly. At least they did until early February, when traders started to challenge the Fed’s forecast ever so slightly. (The contracts are cash-settled against the effective federal funds rate for the particular delivery month.)
The March 2014 contract, for example, peaked at a high of 99.77 on Jan. 30, an implied yield of 0.23 percent, within the Fed’s current 0 to 0.25 percent target. The yield rose to 0.65 percent earlier this week. Volume and open interest shot up, as well. Even the late-2013 contracts are starting to suggest zero isn’t a sustainable equilibrium.
Last week, the unthinkable happened: Long-term notes and bonds took a shellacking even as the Fed gobbles up the equivalent of the Treasury’s long-term issuance.
Not content merely to project a path for overnight rates, the Fed has engaged in several rounds of bond buying since 2009 -- more than $2 trillion of Treasuries and agency mortgage-backed securities -- to ensure that long rates don’t start thinking independently. A manipulated market leaves little room for self-expression, even among those gun-slinging Masters of the Universe.
All Systems Go
In keeping with its policy of greater openness, Bernanke has made it clear that additional quantitative easing is on the table. Economists at Goldman Sachs Group Inc. and Morgan Stanley expect the Fed to announce another round of QE as soon as the April 24-25 meeting -- even before the effort to drive down long-term rates ends in June. (The Fed’s latest attempt to twist the yield curve involves the purchase of $400 billion of longer-term Treasuries and the sale of an equivalent amount of short-term securities.)
Listening to Bernanke and the core dovish camp on the policy committee, it sure sounds as if the onus is on the data to prevent the Fed from acting.
For a central bank whose main focus is inflation expectations (ours) and credibility (its own), appearing to be out of touch is not a great credential. No one would argue that a jobless rate of 8.3 percent represents full employment, one of the Fed’s two mandates (the other is stable prices). But when the Fed says it expects inflation to run “at or below the rate that it judges most consistent with its dual mandate,” you have to wonder what’s in that hookah they pass around the boardroom table.
Never mind that inflation has been running consistently above the Fed’s announced goal of 2 percent. Why would the Fed, with a $2.9 trillion balance sheet, a near-zero benchmark rate for the fourth year running, and a recent history of inflating asset bubbles, be so eager to provide more stimulus when the economy is clearly improving?
“It’s a simple formula,” says Vincent Reinhart, the chief U.S. economist at Morgan Stanley and a former director of monetary affairs at the U.S. central bank. “The Fed has a dual mandate. It’s noticeably short on one, and the other is not a risk. Therefore, it has a responsibility to act.”
I’d add the qualifier “at the moment” to Reinhart’s “not a risk.” The good news in last week’s consumer price index for February was a 0.1 percent gain in the core rate, which excludes food and energy. The year-over-year increase was 2.2 percent, the first dip in the annual rate of change in 16 months.
The Fed’s inflation forecast seems so out of whack, I decided to dig into the February CPI. (The Fed prefers the personal consumption expenditures price index, but the CPI report offers a more detailed breakdown.)
Plusses and Minuses
I first went to Table 1 for the unadjusted year-over-year changes in various categories. Not a lot of minus signs to report. In fact, outside of information technology (computers), energy services (electricity and natural gas), and fruits and vegetables, prices are rising on an annual basis.
Perhaps the Fed is worried about near-term disinflation. I went to Table 2 for the three- and six-month trends. Same story. Fruits and veggies, IT and energy services. Throw in a 7.3 percent decline in used-car and truck prices (seasonally adjusted at an annual rate) and a 0.3 percent dip in apparel, and that’s it for the negatives.
Of course, the Fed’s Phillips-curve model says inflation should be falling because of slack in the economy: specifically, the 12.8 million people who are unemployed. Given the model’s track record -- the Fed’s forecast has been consistently wrong going into the recession and coming out of it -- I wouldn’t put much faith in a series of equations.
Bernanke seems to have a blind spot when it comes to inflation, which is at odds with his advocacy of an inflation target as an academic. Early in his first tour of duty at the Fed as a governor from 2002 to 2005, Bernanke gave a speech on “Deflation: Making Sure ‘It’ Doesn’t Happen Here.” Alan Greenspan was pulling the strings at the time, but Bernanke was among those advocating lower rates, which provided the tinder for the housing bubble.
All this leaves me flummoxed. I’ve been following the Fed for 25 years, in which time the central bank moved from opacity to transparency. Yet with all the light shining in, I have never been more in the dark. Maybe I need a hit on that hookah.
(Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist. The opinions expressed are her own.)
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