Asymmetrical Trade-Offs
On Monday, June 5, in a speech on international monetary issues, Federal Reserve Chairman Bernanke sent shockwaves through the global financial markets. He pointedly characterized recent gains in consumer prices as “unwelcome developments” and further stated that the Fed would “be vigilant to ensure that the recent pattern of elevated monthly core inflation readings is not sustained.”

The tone of Mr. Bernancke’s remarks appeared to be well choreographed with the actions of the global central banks. The European Central Bank increased its benchmark rate to 2.75% from 2.50% and also cited the risks of cost-push inflation pressures from rising commodity prices and burgeoning credit growth. Other rounds of monetary tightening next appeared in India, South Korea, South Africa, and Turkey.

What a change from last month when financial markets were heavily discounting the probability of a pause in the FOMC’s 16 consecutive rounds of rate hikes. With the term fed funds market now assessing a 100% probability of a rate hike resulting from the June 28 – 29 meeting, the Fed appears to be assigning an asymmetric preference for preventing the lasting effects of inflation—even if it is offset by what could be several quarters of sluggish worldwide economic growth.

Reversion to Inversion
The yield curve and global equity markets suggest that the verbiage and rate hikes undertaken by the Fed and other central banks are being taken seriously. Now, attempting to adorn the “bull flattener” label, the yield curve has once again inverted, with yields on the 10-year Treasuries dropping and yields on the two-year Treasuries rising in anticipation of the next rate move. Now straddling 5%, yields on 10-year Treasuries are at their lowest since early April and down 25 basis points from their recent peak on May 12. Yields on the two-year to 10-year Treasuries are currently inverted by five basis points, and we’ll be looking to see if that spread widens and, if so, for how long. Historically, an inversion of in excess of 10 basis points that persists for more than several months has been a relatively good barometer for predicting a protracted slowing of the economy.

Over the past 30 days, there has been a noticeable flight out of virtually all asset classes, into government securities. Gold prices are now 21% off the 26-year highs that were established in April. The NASDAQ has dropped by approximately 12% from its April 19 peak. That date coincided with the Fed’s most recent meeting, where the accompanying statement voiced a somewhat surprising tone of neutrality. Following the market peak, successive inflation statistical releases—including an unexpectedly large hike in the CPI and personal consumption expenditures inflation index that was hovering above the Fed’s preferred upper band of 2.0%—were enough to make neutrality the dissenting opinion.

Inflation Complication
The tightly choreographed dialogue of Fed presidents sums up the Fed’s view of inflation. For example, Sandra Pianalto, president of the Federal Reserve Bank of Cleveland commented that “This inflation picture (an annualized rate of more than three percent), if sustained, exceeds my comfort level.” On the subject of inflation, Richard Fisher, president of the Federal Reserve Bank of Dallas opined, “There is some angst… Everyone is concerned about the possibility of the passing through of gas and oil energy prices.”

Let’s consider recent inflation data:

• Over the past three and six months, the personal consumption expenditures price index has risen at an annualized rate of 3.0% and 2.3%, respectively.
• The core producer price index increased by 0.3% in May; consensus had called for an increase of 0.2%.
• The core consumer price index increased by 0.3% in May—the third consecutive month that the increase exceeded the forecast. A primary reason for the increase: Rents are increasing, as rising interest rates, at least in the short-term, may be increasing the attractiveness of renting, versus purchasing a home. At the core level, consumer prices have increased at an annualized rate of 3.1% for the first five months of the year.
• During April and May, prices of imports registered the largest monthly gain since 1990.

It’s becoming evident that expectations of increasing inflation are prompting the Fed to defend its credibility, given its mandate of wage and price stability. Although the Fed appreciates the lag effect of less accommodative monetary policy on economic growth, recent inflation data are not going to allow the pause that they appeared to be considering no more than a month ago.

More Bark Than Bite?
Notwithstanding the aggravated inflation picture, the lag effect of monetary restraint may be taking hold:

• In May, the University of Michigan consumer confidence index fell to 79.1, from 87.4 in April.
• During April, sales of new and existing homes registered a year-over-year decline of 5.7%. Housing starts and building permits registered respective declines of 7.4% and 5.4%.
• During May, the Institute for Supply Management’s manufacturing index slipped from 57.3% to 54.4%.
• In May non-farm payrolls increased by only 75,000. The total number of hours worked declined. Average hourly earnings increased by only 0.1%.

Indeed, members of the Fed have recently acknowledged that current short-term rates are close to levels that would be sufficient enough to restrain inflation. As an example, this week, Sandra Pianalto stated that the Fed funds target is “near a point that is consistent with a gradual improvement in the inflation outlook.”

So, how are the markets interpreting the outcome of a curmudgeonly Fed, aggravated inflation, and evidence of a slowing economy?

• The term fed funds market, six months out, and the forward markets are currently trading at 5.37%, reflecting a view of roughly even odds of another 25-basis-points round beyond the widely anticipated move to 5.25% on June 28.
• The composite second-quarter GDP growth forecast from select economists that we regularly track, has dipped below three percent. By and large, the consensus outlook calls for a softer housing market, leveling off of energy prices, and moderating economic activity.

The Fed’s recent coordinated credibility-building diatribes against inflation might be put into proper perspective by the financial markets. Even with a prospective funds rate of 5.25%, it’s reasonable to assume that monetary policy remains neutral. Why? The “real” funds rate has historically been in the range of 250 basis points above the rate of inflation. That corroborates with the latest inflation gauges.

We’ll see if the economic textbooks are right in assuming that inflation generally peaks six to nine months after economic growth shows definitive signs of slowing.

John Biestman is director of business development at the Federal Home Loan Bank of Seattle.

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