Losing Control: The Fed at the Crossroads

The June 24-25 meeting of the Federal Open Market Committee will reveal the Fed's attempts to repair the damage from its self inflicted wounds that caused confusion and consternation in the market over exactly what the central banks intends to do about a very real inflation problem.

The last few weeks have not been kind to the market or the Fed. Standing in the heat of a sudden outbreak of hawkish rhetoric, the market quickly priced in up to four rate hikes before the end of the year, sent 30 yr. mortgage rates sharply higher and sent rates on jumbo mortgages up by 70 basis points. The Fed, recognizing the dislocation it had caused in interest rates and rate expectations, walked the market back toward a more reasonable set of expectations. The ten-year and 30 year mortgage rates now stand above where they were in August 2007, before the beginning of the credit crises.

Besides the laughter you hear from the European Central Bank, the major sound that one hears in the aftermath of all of this is the silent residue of shame at the Fed. To be blunt, the inability to craft and communicate an effective message to convince both the market and public of its intent to deal with the sharp increase in the cost of living has damaged the credibility of the central bank. This utterly avoidable episode begs the question: Is the Fed in the process of losing control of both the market and inflation expectations simultaneously?

It is clear that the Fed did not thoroughly think through the reaction of the market to a sudden and inchoate turn in rhetoric. The embarrassing debasement of its own statements after only a few days did not add one ounce of stability to the markets, did little to regain control of long term rates, and failed to put a real floor under the dollar.

Worse (yes, it gets worse), public expectations of future inflation are in the process of becoming unmoored. The University of Michigan’s survey of consumer confidence has seen its one and five year estimates of inflation expectations increase to 5.1% and 3.4% respectively. Inside the Conference Board’s estimate of consumer sentiment, the public now expects that inflation over the next year will increase by 7.7%. Both surveys provide little relief to a beleaguered Fed.

A look at Fed funds futures suggests that the FOMC will remain on hold until September when traders think that there is a 58.5% chance of a 25 basis point hike. Conversely, the options market remains uncertain about the Fed's next move. The difference in expectations caused by the ineffective and ill-conceived statements out of the Fed can be expected to continue until the FOMC begins to craft an effective communication policy that lays out the rationale for its future conduct of monetary policy. With economic growth in the middle of the year looking much more uncertain than it did when Fed adopted a hawkish tone, the case for a fall hike is becoming more diminished by the day, and with it Fed credibility.

Although the disenchantment of investors with Fed is quite clear, the central bank is not without its supporters. Defenders of the Fed would make the case that the central bank has quite a bit of latitude to wait on inflation to subside. Given the slowdown in economic activity, resource utilization and emerging slack in the economy should provide the sufficient relief to inflation the Fed has been looking for later this year. Most importantly, the Fed still does not believe that inflation expectations are very great.

Indeed, what many consider to be the Fed’s preferred indicator of medium term inflation expectations, the five-year forward, has yet to indicate a crisis. This measure, which attempts to strip out near-term pricing disturbances caused by volatile measures such as energy and food prices, gives the Fed a window into what the market anticipates inflation to be five years hence. This important indicator has yet to push back above 3.0% in 2008 after doing just that at the end of 2007.

Perhaps, but waiting on the economy to illustrate sufficient slack, and for the market to catch up with the inflation expectations of the public at a time of major structural change in demand for commodities and energy at the global level suggests a Fed that is intellectually exhausted.

One only need look at the current pricing environment to ascertain the level of risk entailed by current monetary policy. I expect the consumer price index to breach 5.0% in the upcoming June reading. The Fed’s own preferred measure of inflation, the core PCE deflator, should advance to 2.3%; well above the Fed’s implied target range. And, all things being equal, the PCE core rate one year out should be near 2.7%.

Making matters that much more interesting is that core and headline intermediate costs, as suggested by the recent producer price index, are showing signs of reaching a boiling point. On a three-month annualized average total intermediates are up 27.7% through May. Stripping out volatile factors such as food and energy, they are up 18.5% over that same interval. Thus my own forecast may be underestimating what may actually occur. It is now not a matter of if, but when evidence of higher core rates begins to systematically show up in the data.

Firms are close to reaching a tipping point with respect to the costs of production. At some point corporate and small firms will blink and begin to pass through price increases downstream to customers. When that occurs, indicators such as the five-year forward will move strongly past 3.0% and the Fed may be forced to act well before it is actually are prepared.

Moreover, Mr. Bernanke, whose academic reputation rests on the efficacy of a workable inflation-targeting regime, might find it quite difficult to hold off on increasing rates once a preferred indicator breaches a critical threshold. At that point the Fed Chair would face the difficult choice of sacrificing his credibility. That, or move prematurely to hike rates that could send the economy into a much deeper tailspin than the fundamental data currently suggests is probable. Such are the stakes once inflation expectations begin to careen out of control

Losing control of inflation expectations is a fairly solid working definition of the term “loss of monetary credibility.” A majority of countries that employ the inflation targets that Mr. Bernanke champions now have rates of pricing that exceed their formal targets. Unlike Bank of England President Mervyn King, Mr. Bernanke will be spared the ignominy of an explanatory letter of failure to Parliament. But, if the Fed does not regain control of expectations soon, its credibility will be washed away in a sea of rising prices. If so, it will be years before the market or the public once again trust the Fed.