The Federal Reserve: reading between the lines

by George Hatjoullis

The latest FOMC statement from the US Federal Reserve is rather important ( The press and markets were focused initially on the dropping of the word ‘patient’ as a signal that an interest rate hike was on its way. It is, but the FOMC statement indicated that the path of rate increases may be less steep than had previously been anticipated. The latter indicates caution and concern that a policy error is possible. This is the good news.

The bad news is that the FOMC text is hesitant to the point of being inconsistent. The Fed is happy with the progress on employment but seems unable to make up its mind on inflation.

“Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.”

There has been a not very subtle change of language here that was indicated by the Chair in a recent testimony to Congress. Inflation expectations implied by inflation-linked financial contracts are not ‘expectations’ but ‘compensation’. They remain low meaning the market is not worried about inflation and does not demand much compensation. Inflation expectations can only be divined by surveys, according to the Fed, and these surveys show stable expectations. An analogous situation exists with opinion polls for elections. You can bet on outcomes and the implied outcomes from the weight of money often deviate significantly from the polls. No one has dismissed the implied expected outcomes from bets as ‘compensation’ for gambling. If the market does not demand much compensation for inflation risk then there is a reason. Follow the money, it is always better informed. This language suggests an element of denial by the Fed when it comes to deflation risk.

“…the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of energy price declines and other factors dissipate.”

But of course it does! If the Fed did not expect inflation to head back to 2% it would ease further and not be lifting the word ‘patience’. The current low inflation is, according to the Fed, transitory. The interesting thing here that on a 18 month view the Fed always expects inflation to return to ‘target’. This statement appears as a matter of course in all FOMC statements in some form or other. Notice however that the Fed has been wrong consistently since 2008. Otherwise why is inflation not at 2% now? Apparently track record is not important when it comes to central banks. The Fed sets policy, issues a statement that policy should see everything OK in the 18 month time horizon, and ask to be trusted. No one looks back and asks why are we not there yet, Dad?

“The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.”

So, although it expects inflation to move back to 2% in the medium term it is not yet ‘reasonably confident’ of this move. What is the value of an expectation not held with confidence. Confused? You are not the only one. It gets worse.

“The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”

Wow. The Fed really is worried. So even when it hits target it is nervous that the situation will be so fragile that it will be necessary to keep interest rates below ‘normal’ for some time.

The Fed (and all other central banks) clearly does not understand why inflation remains so tame after 6 years of incredibly easy money. It is not consistent with everything the members were taught at university. The response is a nervous denial. It ignores market signals on inflation because the signals tell an uncomfortable story. It speaks of expectations and then admits it has little confidence in these very expectations.

The reality is that global deflation has taken root and to grasp this one must look beyond arbitrary price indices and defunct economic preconceptions. An earlier blog (Understanding the Great Deflation) offers a different, and much less optimistic, perspective.