From a foot-dragging fed to a rate cut too far

From a foot-dragging fed to a rate cut too far

The Federal Reserve sure blew it.

In the week leading up to the Fed’s 18 September meeting, all the chatter was about how the central bank would have to cut its benchmark rate to soothe money markets, get credit flowing again and take out some insurance against recession. If anything, policymakers were dragging their feet.

In the week following the 50-basis-point cut in the overnight federal funds rate, the Fed reignited inflation expectations. At least that’s what I’ve been reading: The first cut was a cut too far.

What a fickle lot these financial markets are! One day investors are worried about asset-price deflation caused by the collapse of the residential real estate market. Twenty-four hours and 50 basis points later, inflation is the big concern.

How can that be? How can the Fed be accused of going too far when it was criticized for not doing enough?

It’s always possible the dichotomy reflects the views of two different groups, with one louder before and the other shriller after the Fed meeting. If that’s the explanation, then I could sign off now.

Let’s look at the evidence to see if the shift is fundamental or flaky.

Federal funds futures contracts began rallying in late July, building in expectations of a 4.5% target rate by year-end.

That was fine and dandy with bond buyers. The yield on the 10-year treasury note plummeted 100 basis points from June to September. Inflation expectations, as measured by the spread between inflation-indexed (treasury-inflation protected securities or TIPS) and ordinary bonds were stable to lower from mid-June through early September.

All was well

So Fed easing was priced into the market, and no one except the gold bugs was too bent out of shape about it.

The Fed delivers on 18 September, cutting the funds rate by one-half point rather than the more widely anticipated quarter point, and suddenly it’s curtains for bonds?

Treasury 10-year note yields rose 40 basis points in September before retreating a bit this week. This can be seen as either a fundamental statement or a technical trade, the result of arbitragers buying short-term treasuries and selling long-term bonds, which is a standard play when the Fed is lowering rates.

TIPS spreads started to widen (inflation expectations rose) shortly before the Fed meeting, shooting up about 15 basis points before retreating, based on five-year inflation expectations five years from now.

With more grim news on housing on Tuesday—on sales, prices, inventories and home-builder earnings—inflation expectations should retreat as well, although the relationship between the two is hardly fixed.

Demand weak

Too often we talk about inflation and recession as if they are polar opposites. They’re not. The 1970s taught us that high inflation and sub-par growth or recession can coexist, albeit not peacefully.

It served as a welcome reminder, not to mention real-time lesson, that growth doesn’t cause inflation; too much money, courtesy of the central bank, does.

In the past year, the rate of inflation has slowed, even with oil and other commodity prices soaring and the dollar sinking.

“That tells me that demand has been weaker than we thought," says Jim Glassman, senior US economist at JPMorgan Chase & Co.

The core CPI (consumer price index), which excludes food and energy, peaked at a year-over-year rate of 2.9% in September 2006 and stood at 2.1% last month. The CPI has been coming down in fits and starts as well, from its cycle high 4.7% in September 2005 to 2% in August.

Low correlation

Raw materials prices have been on the rise since the end of 2001, without much noticeable effect on finished goods prices. In part, that’s a reflection of the “services-based" nature of the US economy, with labour costs a more significant input than commodities, says Ian Shepherdson, chief US economist at High-Frequency Economics in Valhalla, New York.

A second reason is the small effect raw materials have on finished goods prices. Shepherdson did some calculations and found that “a 30% increase in raw materials prices generates a mere 2.5% rise in finished goods prices." That, in turn, translates into a CPI core goods price increase of 0.5%.

“In other words, it would take an enormous, sustained rise in core commodity prices to push up overall core inflation in a meaningful way," he says.

Fed’s actions

Sensitive materials prices such as copper, lumber and steel are traded on the world market and act as a better indicator of demand than inflation. Emerging market economies such as China and India have been gobbling up commodities, but the rise in prices has yet to manifest itself in inflation, defined as a rise in the price level.

What else could explain the shift from recession fear to inflation phobia in the last couple of weeks?

“The Fed had an inflation bias back in August," says Joe Carson, head of global economic research at AllianceBernstein. “They restated it in September," saying some inflation risks remain.

In this case, the Fed’s actions speak louder than its words.

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