Inflation and the Fed: Moving the Goalposts

Written by: Global Thought Leadership | January 12, 2018

Source: Bloomberg and Legg Mason, Jan 11, 2018. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

The Bottom Line

  • Is the Federal Reserve’s inflation target overdue for an update?
  • Interested parties have been quietly discussing a substantial shift, prompted by the Fed’s limited success in hitting its inflation target – despite aggressively accommodative monetary policies.
  • In January 2012, the Fed set a 2% target rate for inflation in a first-ever “longer goals and policy strategy” statement.
  • Yet since then, the Fed’s favored inflation measure, the core Personal Consumption Expenditure (PCE) deflator, has mostly stayed well below that 2% target. Despite coming close toward the end of 2016, it’s fallen since then to a low of 1.30% in August 2017. As of November 30, the most recent figure is available, the rate stood at 1.50%.
  • So it’s not surprising that outgoing Fed chair Yellen said in her final Fed press conference that achieving the 2% goal is on her “undone list” and remains important to achieve, but “could end up being something that is more ingrained and turns out to be permanent”.
  • But that then begs the question: What does this do to today’s market expectations of the Fed’s success in the coming years?
  • One possibility: the “5-year / 5-year breakeven inflation rate” derived from the prices of Treasury Inflation-Protected Securities (Treasury “TIPS”) and the prices of corresponding Treasuries that don’t carry inflation protection.
  • Simply put, this number represents the market’s current expectations of the rate at which TIPS and Treasuries would be of equal value.
  • As it happens, the 5 year – 5-year breakeven rate doesn’t suggest inflation is going to surpass 2% for any extended period over the coming 5 years – disappointing news for all who’d hoped rising employment would kick-start a benign wage-price spiral by now.
  • Of course, economists both inside and outside the central bank have their own alternatives to guide the Fed, including a focus on achieving a “natural” interest rate or setting a fixed rule to govern monetary decisions.
  • Time will tell whether the incoming Fed Chair and Vice-Chair will endorse a change, or if the current gradual, clearly-communicated policies will continue, supporting today’s historic length of record-low volatility.
  • The bottom line: Markets favor predictable processes and objectives.  To the extent that changing objectives are in the offing, the hope is for continued clarity in communicating the whys and wherefores, as well as continued stable, synchronized growth.

Top

U.S. Treasury Inflation Protected Securities (“TIPS”) are bonds that receive a fixed, stated rate of return, but they also increase their principal by the changes in the CPI-U (the non-seasonally adjusted U.S. city average of the all-item consumer price index for all urban consumers, published by the Bureau of Labor Statistics). TIPS, like most fixed income instruments with long maturities, are subject to price risk.

U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.

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