The Dangers of the Bond Market’s Disagreement with the Fed

Right now, we have an unusually apparent difference of opinion between the market and the Fed. Bernanke in his Congressional testimony last week said as clearly as a Fed chairman could that the Fed thought growth prospect for the economy were solid and was concerned about the risks of inflation and plans to keep rates where they are. The markets expect two rate cuts this year.

This may be a simple disagreement about the trajectory of the economy. But Krishna Guha in Monday’s Financial Times, “Out-of-step markets may be misreading the Fed,” offers another, more problematic possibility:

If the difference boils down to the forecast, there is not too much to worry about. But there could also bea malign explanation for the gap between the market and the Fed. It is that the market may not properly understand how the Fed will respond to any given set of data. Investors may be underestimating the Fed’s determination to see inflation – which rose rapidly in February – come down and its anxiety that it may not do so.

They may also be overestimating the Fed’s discomfort with low growth that is currently running at an annualised rate of roughly 2 per cent. Gary Stern, president of the Minneapolis Fed, says the economy is not “fragile”. The Fed sees no reason why today’s sub-par growth should deteriorate into recession rather than eventually pick up as the drag from housing fades.

Officials worry that inflation may prove more persistent than they expect. They also worry that if inflation gets stuck at an unacceptably high level, bringing it down again could be very costly.

If investors do not understand the Fed’s “reaction function”, there is a much greater risk of market turmoil, because the Fed and the marketmay draw different conclusions from the same data.

More worrying still, investors may not fully grasp what the Fed is trying to do because the Fed itself cannot agree on this. Frederic Mishkin, a Fed governor, recently exposed a simmering debate within the Fed’s policymaking committee. It concerns whether the Fed should be content with getting inflation down to 2 per cent or a fraction below, or push on towards the middle of the so-called “comfort zone” of 1 to 2 per cent inflation.

This argument would be swiftly set to one side if the economy went into a tailspin. But in a less clear-cut situation, Fed hawks may be reluctant to accept rate cuts even if inflation is on track to fall to 2 per cent, for fear of endorsing this as the central bank’s ultimate objective. In the worst case, this could saddle the Fed – like the European Central Bank in its early days – with policy inertia.

Which explanation is right? The best guess is that the benign explanation – an honest difference of opinion over the economic outlook – is the predominant factor. But there is enough of a hint of the malign explanation to raise concern. How Mr Bernanke must wish he had the inflation target regime he wants in place.

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