Credit Markets Betting Against the Fed?
On December 16, the Federal Reserve raised interest rates for the first time in nine years. Such an important move deserves close analysis. In her news conference of the 16th, Janet Yellen staked her rate hike decision on inflation expectations... that the potential for "overheating" in the economy "requires" modest monetary "tightening" now.
Credit Markets Betting Against the Fed?
On December 16, the Federal Reserve raised interest rates for the first time in nine years. Such an important move deserves close analysis. In her news conference of the 16th, Janet Yellen staked her rate hike decision on inflation expectations... that the potential for "overheating" in the economy "requires" modest monetary "tightening" now. The Fed wants inflation-and by this they mean Consumer Price Inflation (CPI) -- because inflation and growth are intimately linked in their economic models. Therefore, the Fed has an inflation target of 2% which the Fed has failed to meet for more than 30 months. The problem is that there is no evidence of inflation as the Fed measures it.
First, let's look at the CPI. The all items index has risen 0.5 percent over the last 12 months...the largest 12 month increase since the 12-month period ending December 2014 but hardly evidence of overheating. The Chained Consumer Price Index for All Urban Consumers (C-CPI-U preferred by policy makers) increased by just 0.1 percent over the last 12 months. Where is the "overheating" uptrend in the following CPI chart from the Bureau of Labor Statistics?
If inflation is important to the Fed, as they continually say it is, and inflation is running well below their target, as it clearly is, why would the Fed raise rates when their models say that tightening puts downward pressure on inflation?
Even stranger, the Fed has a preferred market-driven measure of expected future inflation...the so-called "breakeven" inflation rate which is essentially the difference in interest rates between Treasuries and inflation-protected TIPS. This measure has the advantage of being determined by investors who have money on the line.
The Fed especially relies on the 5-year breakeven inflation rate -- the difference between the 5-Year Treasury Constant Maturity Rate and the yield on an inflation-protected TIPS security with 5-years remaining to maturity. As can be seen from the graph below, the breakeven inflation rate has been plunging since June, 2014. Clearly, credit markets are expecting slower growth and lower inflation, not overheating. Not coincidentally, June 2014 was also when the dollar began its bull move while the oil price accelerated downward. The Fed wrongly declared the drop in oil to be "transitory" and that the inflation rate was expected to move back up to their target. Wrong again.
Note that the forward rates first collapsed in September 2008, surged in late October/early November 2008 and then crashed again much harder, as the market completely lost faith in the Fed. Could that be happening now?
Also note that when the forward rate fell rapidly again in 2010, it was Bernanke's aggressive QE2 package that brought inflation expectations back into line with Fed policy. The forward rate is now below the levels that provoked QE2. Are we going to see a repeat performance?
At her December 16, 2015 news conference, Chair Yellen confirmed that the decision to raise rates reflected a "reasonable confidence that inflation would move back to 2 percent over the medium term." Where is the evidence? Can she be right and the market wrong? Can the Fed rate hike survive?
As stated by Jeffrey Snider of Alhambra Investment Partners, "the Fed's preferred number is saying in 2016 that there is little to zero faith in either the economy or monetary policy in either the short-term or beyond it...yet again the FOMC and economists are not just hopelessly out of touch but downright delusional, describing an economy that nobody else can find."