federal reserve

Guidelines for a rate hike

Thursday Nov. 5, 2009
Posted 3 p.m. Eastern

The Federal Open Market Committee concluded their meeting yesterday, and as expected, held rates steady. As for the much scrutinized statement issued afterward there were just minor tweaks here and there, such as an acknowledgement that household spending "appears to be expanding" and economic activity "has continued to pick up."

Perhaps most significantly, the Fed retained the language about "exceptionally low levels of the federal funds rate for an extended period." But in so doing, the Fed laid out what essentially are three guidelines for a rate hike -- low rates of resource utilization, subdued inflation trends and stable inflation expectations.

Resource utilization is a measure of how much unused capacity exists in the system, and currently 30 percent of capacity is idle. The Fed feels that prices won't rocket higher with that many factories or production facilities running below capacity.

Regarding subdued inflation trends, yes inflation is certainly subdued and the expected tepid recovery in major developed economies worldwide means we're not likely to encounter the inflationary "too many dollars chasing too few goods" any time soon. But this tends to be somewhat backward-looking as it relies on data that show a change in the trend, and since monetary policy acts with a lag of 9 to 18 months, relying too heavily on actual price data risks the Fed falling dangerously behind the inflation curve.

Which brings us to the third component: inflation expectations. At least this is a forward-looking measure. Now all we need is the Fed to actually pay attention to it and act accordingly. I'm more than a little concerned about whether they have the fortitude to do that.

Inflation expectation can be discerned from different indicators, such as gold, oil and other commodity prices, or the difference between yields on nominal Treasury securities and those of comparable maturity Treasury Inflation Protected Securities, or TIPS. This difference, known as the breakeven rate, is an often-used barometer of inflation expectations because it is the rate of inflation that would equate the return on TIPS with the yield on a Treasury of the same maturity.

It likely comes as no surprise to you that inflation expectations, no matter how you measure them, are moving higher even in this environment of "subdued" inflation. Gold prices are at an all-time high, pushing $1,100 an ounce. Oil has climbed above the $80 mark, double the level of earlier in the year despite a less than robust global economic rebound. And even the breakeven rate between 10-year Treasuries and 10-year TIPS has increased from 164 basis points on Aug. 31 to 175 basis points on Sept. 30 and 200 basis points as of Oct. 30.

Very clearly, inflation expectations are on the rise. How much further they rise and what, if anything, the Fed is willing to do in response are items both worth watching.

Comments? Questions? Please let me know.

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