Once again, rather than the Federal Reserve guiding expectations, it is the market calling the shots this time in correctly expecting fewer and later rate rises.
Yet another rapid drop in the price of oil has helped push consumers’ longer-term expectations of inflation further away from both the Fed’s target and its claims of where it will be in future years.
Even relative hawks and insiders like James Bullard, President of the St Louis Federal Reserve, are now expressing reservations about policy, less than a month after helping to push through the first rate rise in nearly a decade.
“With renewed declines in crude oil prices in recent weeks, the associated decline in market-based inflation expectations measures is becoming worrisome,” Bullard, a voting member of the Federal Open Market Committee, said in a speech on Thursday.
And though he acknowledged that the Fed usually discounts substantially the temporary impact of energy price changes, he noted that “one circumstance where one may be more concerned is when inflation expectations themselves begin to change due to the changes in crude oil prices.”
Concern about this is coming from both inside and outside the Fed tent, and from hawks and doves.
Narayana Kocherlakota, until January 1 the president of the Minneapolis Fed, sent a tweet on Wednesday expressing concern: “Very worrisome signal for Fed credibility as 5 yr 5 yr forward breakevens plumb new lows.”
The five-year breakeven inflation rate, which express where the bond market expects inflation to be over the coming five years, have been sinking rapidly in the New Year, tracing the decline of oil and the stock market, and now touching just 1.19% this week. That’s moving the wrong direction from the Fed’s 2% target, an aspiration which the forward market has not endorsed since July of 2014.
To be sure, Kocherlakota, a dove’s dove, was needling his former colleagues, with whom he has long-standing and seemingly intractable disagreements about the direction and mechanics of inflation. Still, at the point at which Bullard gets involved in this way, it is time to take seriously the idea that the fall in energy prices might force a rethink of the course of policy.
It is also important to remember that the bond market does roughly as good a job forecasting inflation as the stock market does of divining future corporate earnings or the timing of recessions. Which is to say both are often wrong.
Oil taketh away, oil giveth
NYMEX crude oil has fallen to just US$31 per barrel in the past month from above US$38, having been above US$60 within the past year. Global readings on the manufacturing economy have also been sinking, spreading concern over the possibilities of a marked slowdown in 2016.
Reacting to this set of circumstances won’t be an easy or low-risk process for the Fed. The growing worry is that inflation expectations become unmoored, but rather than float away they just sink. Japan, which has battled deflation with little success for more than a decade, is an object lesson in the potentially very high costs of this.
Yet the US consumer economy is finding low inflation of the cheap energy variety to be rather pleasant. Job growth is strong, auto sales continue to set records and there are some signs that wage growth may at last come through.
“How can the US economy create 257,000 jobs when the dollar is strong and oil prices are low and HY energy spreads are widening?” economist Torsten Slok of Deutsche Bank wrote in a note to clients.
“Because the elephant in the room is the service sector, which benefits from lower oil prices. Bottom line: Don’t interpret 10-year rates in the US at 2.2% as a sign that the US economy is unhealthy.”
It is interesting to note that the European Central Bank, faced with a similar drop in market expectations for interest rates, expressed concern in the minutes of its December policy meeting about exactly how much information those prices contain.
The most likely outcome in the US is that the market wins but victory is far from total. Having begun to raise rates, the Fed will want to carry through at least once or twice, though it is unlikely to hike four times in 2016. Instead we’ll probably see a delay in hikes and a lower end point.
This will probably satisfy neither the stock nor bond markets, with inflation expectations perhaps falling along with risky securities.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
