Release The Fed’s Doves

While the Federal Reserve (the Fed) remains highly focused on achieving its mandate for growth, of equal importance is achieving its mandate for 2% inflation and overall price stability. On both, it is still some ways away. As a result, the Fed (and all central banks) is highly sensitive to shifts in inflation expectations by either consumers or the markets. Consumer measures of inflation expectations via surveys typically move slowly and are available only monthly. Market measures of inflation expectations are available in real time via TIP breakevens; these represent the difference between nominal Treasury yields and their TIP (real yield) counterparts across various maturities.

Most investors focus on long-term measures five or 10 years ahead for signs of shifting perceptions of the inflation environment. But short-term TIP breakevens are just as important, serving as a proxy for inflation expectations in the year ahead. Negative readings signal rising deflationary risks, even if they prove temporary. Indeed, these measures provided a warning in early to mid-2008; they flagged the collapse in demand and deflationary forces bearing down on the economy as the U.S. financial crisis and recession deepened. The measures also fell below zero during the U.S. fiscal cliff crisis in 2012, signaling the potential deflationary impact of immense tax hikes hitting demand. In both those instances, the Fed leaned in and accelerated QE and balance sheet expansion to counter those forces.

Exhibit 1: TIP breakevens

So we should take notice when short-term TIP breakevens fall and begin to turn negative, which is the case now (Exhibit 1). The one-year TIP breakeven fell below zero in mid-September and, at -0.75 basis points, appears to be pricing in some deflationary pulse in the next year. This metric is now the worst since fiscal cliff period in 2012 and, before that, the financial crisis. It is also pulling down longer term inflation expectations across the curve. While commodity prices have also broken down, declines in commodities and breakevens together may be symptomatic of a larger concern over a (perhaps temporary) shortfall in demand. Breakevens are falling across most other developed markets too. One possible source is the combination of slowing economic momentum in the eurozone, Japan and China which might feed back into the U.S. and become self-reinforcing. But even if that slowdown does not become more onerous, this weaker price environment is also intersecting with two other factors: the end of QE in the U.S. (diminishing liquidity) and a possible Ebola scare (inciting fears of weaker global commerce and trade, even if the drag is marginal, which exacerbates the deficiency in demand). The University of Michigan consumer inflation survey out Friday also saw short-term inflation expectations fall to its lowest level since 2010 when the economy was recovering from the recession.

The potentially negative signal for U.S. inflation obviously worries Fed officials. Indeed, as both the one-year breakeven and the stock market fell deeper into negative territory early Thursday, it was no surprise that the Fed’s speaker circuit kicked in with calming comments from St. Louis Fed President Bullard in a late morning interview. He noted concern about the drop in inflation expectations, saying the Fed must be ready to act to defend its inflation goal and—somewhat shocking—should consider delaying the end of QE and asset purchases to halt the decline in inflation expectations. Words move markets, and the equity correction quickly reversed. But short-term breakevens were little moved and much depends on their direction.

We don’t know the causes for the decline in inflation expectations, and there are numerous candidates. But it is obvious the withdrawal of QE is now proving a challenge for the Fed. I would be cautious until we understand what is driving inflation expectations and if the decline is temporary. I still believe the fundamentals in the U.S. are sound, both near term and longer term with only modest negative follow through to earnings from a strong dollar and weaker global demand. My expectations for growth are unchanged at 2.5%-3.0%, with only a modest drag from a stronger dollar. I am concerned though there may be some larger shortfall in demand next year for some reason we do not yet know.