The Fed’s Self-Delusion (Inflation Edition)

Individuals and institutions are capable of considerable self-deception when faced with difficult choices. The Fed’s latest signals about what it intends to do about inflation are a classic example.

Both Bloomberg and the Financial Times tell us that the central bank stands ready to raise rates quickly to ward off inflation. From Bloomberg:

Federal Reserve officials signaled they are prepared to quickly reverse last month’s interest-rate cuts after concluding that borrowing costs need to be kept low for now.

Policy makers cut their 2008 growth forecasts and said that rates should be held down “for a time,” minutes of their Jan. 29-30 meeting showed yesterday. They also called inflation “disappointing,” and some foresaw raising rates, possibly at a “rapid” pace once the economy recovers.

This little scenario is very convenient and very unlikely to happen. First, we are already seeing signs of inflation in the real economy, as anyone who goes to a grocery store will attest. I don’t know about other readers, but I find myself starting to exhibit classic inflation behavior, stocking up on goods that are rising rapidly in price (if I could hoard milk, I would).

Second, conventional market-based measures of inflation expectations may be distorted by the flight to quality induced by the credit market crisis (why the Fed looks only at fixed income markets and not commodity prices is beyond me). Many experts place great stock in the fact that the spread between ten-year TIPS and ten-year Treasuries has hardly budged in the last two year.

But again, I wonder. TIPS aren’t a great inflation hedge; their yields are adjusted based on CPI, and as we all know, CPI by design is lower than broader measures of inflation. I wonder if they are becoming a dumb money product, and savvier investors worried about inflation are using other investments to hedge inflation exposures. Remember, ten years ago, only the bravest (as well as the most naive) retail investors would trade commodity futures. Now any retail player can get commodity exposures easily through a variety of ETFs and ETNs.

And most traditional benchmarks are show higher expectation of price increases. Indeed, the Cleveland Fed takes issue with the simple reading of TIPS spreads. From the Financial Times:

Crude comparisons of the difference in yield between ordinary Treasury bonds and Treasury inflation-protected securities show little change.

But these measures do not take into account the jump in the liquidity risk premium since the start of the credit crisis, which increased the attractiveness of more liquid ordinary bonds.

Adjusting for this, the Cleveland Fed calculates that the inflation rate the market expects to prevail over the next 10 years has risen sharply, from 2.3 per cent at the end of July last year to 3.2 per cent today.

Using a different approach, Macroeconomic Advisers estimates that the inflation rate expected to prevail over a five-year period starting five years from now has gone up from roughly 2.5 per cent last spring to 2.96 per cent today.

Some survey-based measures of inflation expectations have also edged up, although they remain much more stable than market-based measures.

Jim Hamilton at Econbrowser has a longer-form discussion of the inflation data and Fed statements.

But the Fed tells itself not to worry:

The Fed minutes argue that the market-based measures may exaggerate the move-up in expected inflation. Changes in recent months “probably reflected at least in part increased uncertainty – inflation risk – rather than greater inflation expectations”.

One has to wonder if this is rationalization, since the Fed is unwilling to contemplate a rate increase now, or even a halt in cuts, given the shakiness of the financial system.

We’ve had stagflation before. We are now experiencing asset price deflation and commodity price inflation, and the powers that be are fighting the deflation. For a time, manufacturers may suffer some margin compression to avoid increasing consumer prices too much, but higher commodity prices in the end will lead to consumer prices (unless we have a severe recession that leads energy and metals prices to fall. But that won’t give much relief to agricultural prices). Indeed, some analysts argues that the increase in retail sales in January was strictly inflation-induced.

Moreover, even if the Fed is right and inflation isn’t rising all that quickly (yet), I doubt its ability to change its policy on a dime. It was slow to recognize the depth of the subprime/credit mess, and has tried to play catch up with rapid and fairly large rate reductions. It now seems complacent about inflation, when inflation expectations are slow to build but difficult to reverse. And the Fed is very afraid of crossing Wall Street, and interest rate increases lead to lower securities prices, at least when they translate into higher prevailing interest rates. Note that the 17 rate increases the Fed implemented prior to the real estate reversal had just about no impact on the price and availability of credit. Now that lenders and investors are more cautious and the securitization machine is down for repairs, Fed rate increases might have more impact than they did the last go-round.