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Nejat Seyhun
  Nejat Seyhun
 

Inflation Expectations and the Fed's Next Move

2/15/2011 --

Ross professor Nejat Seyhun says Federal Reserve needs to focus on rising consumer prices.

We are getting a number of conflicting signals about important risk factors in the economy. Some signals are up and some are down, painting a particularly confusing picture.

Unemployment is down to 9 percent, even though the economy does not seem to be generating a lot of jobs. Much of the decline in unemployment seems to be due to the fact that some people are so discouraged that they are not even looking for a job. Housing starts have been stuck in the 500,000 range for over two years, and they are still down about 50 percent from their peak.

In contrast, GDP has been growing fairly robustly, most recently about 3.2 percent. A recent survey of 55 economists revealed that that GDP growth will further increase to about 3.5 percent by year's end. The stock market is doing very well, erasing most of the losses from the financial crisis, and the S&P 500 is expected to hit record levels in 2011, surpassing its 2008 peak.

Yet, in his testimony before Congress, Federal Reserve Chairman Ben Bernanke said it is too early to reverse, shut down or even slow down the monetary faucet, in spite of all these improvements. He indicated that there is no current inflation and that some of the inflation concerns are overblown. The Fed also said it is vigilant and ready to pull out liquidity if and when inflation rises. For his evidence, Bernanke pointed out the low 1.5 percent year-on-year CPI inflation, even though CPI can have genuine measurement problems with respect to the exact nature of substitution effects and quality adjustments.

Meanwhile, massive levels of monetary and fiscal stimuli continue. The Federal Reserve is determined to continue with the $600 billion purchase of 10-year Treasury Notes, even though it has brought its balance sheet assets to a record-$2.5 trillion. At this rate, the Fed's balance sheet could hit $2.8 trillion by summertime. All in all, the Fed's asset base has expanded by $1.7 trillion during the financial crisis.

The fiscal stimulus also continues. The fiscal year 2012 budget deficit is likely to surpass $1.6 trillion---quite alarming to a lot of investors. Other indicators of inflation are also signaling alarm. While CPI inflation is low, gold is trading at near record-levels and commodity prices, especially wheat, cotton, corn and soybeans, are up 50-100 percent in the last six months. This entire picture seems to be quite confusing to the average investor. Is there or is there not a threat of inflation? At what level of inflation will the Fed intervene and start cutting liquidity? This is quite the 64,000 dollar question.

The fact the Ben Bernanke is reluctant at this time to even entertain the possibility of slowing down the monetary faucet is also quite worrisome since it suggests the possibility that much of the recent improvements in the economy are due to massive monetary and fiscal stimuli. Absent the crutches, Bernanke seems to be worrying that the economy and the stock market can easily roll back.

It is also becoming quite clear to a lot of investors that most of the bullets with respect to monetary and fiscal policy are already spent. It is quite unrealistic to expect the Federal Reserve to expand its balance sheet by another $1.7 trillion or for the federal government to continue with $1.7 trillion-a-year deficits. What will happen if monetary and fiscal stimuli are stopped?

All of this makes inflation a key figure to which to pay attention. Clearly, commodity prices and CPI are backward-looking, noisy measures of historical inflation. They may or may not provide good guides to future inflation. We need a less noisy, forward-looking inflation measure. A good forward-looking inflation measure is the difference in the yields of 10-year Treasury notes and 10-year Treasury Inflation-Protected Securities. This is a market-based long-term inflation expectations figure.

This forward-looking inflation expectation has averaged 2.06 percent for the entire year 2010, which is pretty close to the Fed's tolerated range. For the last month-and-a-half, the average daily inflation expectations inherent in the Treasuries have risen to 2.34 percent, with a most recent reading of 2.28 percent as of Feb. 14 closing prices.

Clearly, market participants are indicating that inflation expectations going forward are increasing. So far, the increase in inflation expectation in reaction to all the stimuli has been mild, thereby justifying the reluctance on the part of the Fed to act soon. There is no guarantee, however, that market expectations of inflation will not be jolted sometime in the future.

In my view, it would be a good idea to focus on this inflation number as a potential guide to Federal Reserve's next move.



For more information, contact:
Bernie DeGroat, (734) 647-1847, bernied@umich.edu