March 9, 2010The employment report of February summed up the current economic situation as showing small positive improvements from the prior month, with many worrisome aspects still in place. Lest we forget other notable developments in the market place; these pictures are on our watch list among many other economic and financial variables we follow. Inflation stories are floating around, particularly in relation to the size of the Fed's balance sheet. As usual, there are two camps - one that fails to see inflation as a major concern given the fundamentally weak status of the economy, and the other focusing on the explosion of the Fed's balance sheet since late-2008. Inflation expectations are important, no doubt. The market measure of inflation expectations (10-year U.S. Treasury note yield minus 10-year TIP rate) was 2.13% on February 26, down from a high of 2.43% on February 3 and was trading at 2.21% on March 5 (see chart 1). Essentially, these numbers imply there is no inflationary threat around the corner.
The Fed's balance sheet is frequently cited as a source of inflation in the months ahead; it has grown to $2.26 trillion from $2.0 trillion in the mid-2009 (see chart 2) but it has yet to move significantly higher than the level recorded in late-2008. Roughly 50% of the financial accommodation provided is being held in the form of excess reserves. Therefore, until excess reserves are converted to credit, the inflation scare is a mirage. The effective federal funds rate closed at 11 basis points on February 24 and was 17 basis points on March 5. One day's mark is not a trend, but the March 5 reading of the effective federal funds rate has caught our attention. It is being explained partly as a technical issue. It appears that if this is the beginning of new trend, the arbitrage opportunity of banks is gradually vanishing into the horizon. Is this another aspect of the Fed's exit strategy in operation? Is it a one-off event? The answer is unclear, but we are watching closely.
The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions. (c) Northern Trust
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