Inflation and Interest Rates

The Federal Reserve began its first asset purchase program in the fall of 2008, during the depth of the financial panic. Some observers feared that the Fed’s actions would fuel higher inflation. However, the Fed is now well along in its third asset purchase program and inflation (as measured by the PCE Price Index) has remained low. In fact, Fed officials expect that inflation will trend at or below the 2% target for the next couple of years. That hasn’t stopped the inflation worrywarts from predicting that inflation is still “just around the corner.”

Inflation is a monetary phenomenon, but we observe it building through pressure in resource markets. The soft global economy has put downward pressure on commodity prices. The large degree of slack in manufacturing means that we’re unlikely to see bottleneck pressures pushing inflation higher anytime soon. Most importantly, high unemployment should continue to keep labor costs in check.

The inflation process also depends on inflation expectations. Higher inflation expectations tend to become self-fulfilling. However, the market continues to show that inflation expectations remain contained. The spread between inflation-adjusted and fixed-rate Treasury securities isn’t an exact measure of inflation expectations (there is a liquidity premium in the price of fixed-rate Treasuries and an inflation-uncertainty premium in the price of TIPS), but it does provide a reasonable first approximation. Well-anchored inflation expectations reflect confidence in the Fed’s commitment to keep inflation low over the long term.

What about gold? Isn’t gold an indicator of inflation fears? Not really. Gold is not the inflation hedge that many people assume it to be. However, gold is certainly sensitive to hype. In recent years, the drumbeat on gold has been hard to ignore. However, few people seem to remember what happened in the 1970s. Gold rose sharply, the fell just as sharply. I can recall my barber bragging about how much money he made just before the top (the barber indicator is almost foolproof, I received similar comments about certain tech stocks at the peak of that bubble too). The gold bugs have a compelling story. Gold has long been a traditional store of wealth. However, there’s no reason that currencies have to be tied to gold. More importantly, the main reason to buy gold, according to the gold bugs, is that inflation is “sure to take off.” Yet, inflation has been remarkably low and is expected to remain low.

Fixed-income investors, we should point out, have been locking in negative real returns in Treasuries for some time now. Does that mean they expect inflation to rise? No. The spread between TIPS and fixed-rate Treasuries reflects inflation expectations. Instead, negative TIPS yields reflect the very strong demand for safe assets. Such demand should not have been unexpected following a severe financial crisis. The demand for safe assets has kept long-term interest rates low amid the increase in government borrowing of the last few years. At some point, as the economy recovers, the government’s borrowing costs will rise. However, in the near term, the federal budget deficit is set to decline further.

What about the Fed’s exit from accommodation? Can the Fed unwind at a pace sufficient to prevent inflation from taking off? The Fed is confident that it can drain reserves from the system when appropriate. It can execute reverse repos and offer time deposits to depository institutions (the Fed continues to test these facilities regularly). It can raise the interest rate it pays on excess bank reserves held at the Fed. It can let its assets mature naturally over time. The worst case scenario, which we’re unlikely to see, is outright sales from its portfolio.

Meanwhile, the low inflation outlook should allow the Fed to remain very accommodative until the labor market shows substantially better improvement.

© Raymond James

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