Inflation: The Fed's New Reaction Function

Mid Week Bond Update

Inflation: The Fed's New Reaction Function

Behind the Fed's rate decision: a change in the way the FOMC views inflation.

The Fed’s rate decision on September 18, 2019 could easily eclipse the importance of another recent topic of debate within the FOMC: whether it should tilt future policy more directly toward one of its overarching mandates: managing inflation.

The Fed’s well-known steady-state 2% inflation target, as measured by core personal consumption expenditure (PCE) inflation, has been surpassed in only two relatively brief periods since the 2008-9 financial crisis. This year, at of the end of July 2019—the most recent available figure—it languished at just under 1.6%. Meanwhile, the continuing strength of the labor market has yet to generate the wage inflation believed necessary to push overall inflation upward. The issue is more than technical: it affects how the Fed will react to future economic news.


Chart courtesy of Western Asset. Source: Bloomberg, as of 8/31/2019. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.


Western Asset’s John Bellows believes a change in the Fed’s “reaction function” may have already taken place, and that its new focus will be on “realized inflation”, meaning the FOMC would no longer base its rates on forecasted inflation, but rather on inflation when it is actually seen and measured in the economy. By that standard, the likelihood increases of a more aggressive set of rate cuts than seen recently.

On the rise: U.S. high yield energy debt

One of the few certainties surrounding the recent disruption of Saudi Arabia’s short-term ability to deliver crude oil: the crippling attack offers a welcome, if temporary, short-term reprieve for struggling energy exploration and production (E&P) companies. The relief is evident in the Bloomberg Barclays High Yield Energy Index, which has risen over 4% since August 15, 20191, bringing the average option-adjusted spread (OAS) over the same interval down from 7.556% to 6.060%, some 150 basis points. Ex-energy, the index spreads declined less -- from 4.000% to 3.200% (80 bps) -- suggesting that over half the move in spreads was due to activity in the energy business alone.

Although not all crude oil is created equal from a processing and shipping standpoint, many analysts suggest the estimated 5% short-term shortfall in global crude oil supply can be easily absorbed by other producers in the short-to-intermediate-term future. But the longer-term impact of the attack may be in the risk premium that market participants will embed in crude oil prices going forward to compensate for the newly-realized challenges in the markets for crude.

On the slide: Overnight availability of U.S. dollars

Banks trade with each other, and with the various Federal Reserve Banks (New York, Chicago, St. Louis, etc.) in order to meet their needs for ready cash to pay interest, dividends and principal on loans they make and deposits they hold. The instruments they trade include “repos”, which are generally priced based on the Fed’s overnight benchmark rates – except when there’s a sudden demand for cash, fund checks written for corporate tax payments, or coupons on issued Treasuries. That’s indeed what happened September 16-17, 2019, and it drove the interest rate on repos from roughly 2.25% – the Fed’s benchmark overnight rate – to as high as 8.5% or more for several minutes. In response, the Fed immediately provided liquidity to the market by buying $53.2 billion of securities for its own account.

Most observers accepted the explanation for the short-term cash crunch, but some participants observed that the Fed might be better served by creating a standing ability to supply liquidity on demand by the market rather than stepping in on a case-by-case basis – given the unlikely but far-reaching nature of any systemic risk in the vital interbank system. All parties are mindful of the fact that the interbank markets were an integral part of the “transmission mechanism” that amplified the effects of the Great Financial Crisis of 2007-9. The Fed’s rapid reaction to the liquidity crunch in the overnight market shows the Fed’s awareness of the importance of keeping markets liquid on a minute-by-minute basis.


All data Source: Bloomberg, September 17, 2019, unless otherwise indicated.


1 Source: Bloomberg, September 17, 2019, 1:30 PM ET


The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

The Federal Open Market Committee (FOMC) is a policy-making body of the Federal Reserve System responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

A repurchase agreement, or repo is a contract under which the seller commits to sell securities to the buyer and simultaneously commits to repurchase the same (or similar) securities from the buyer at a later date (maturity date), repaying the original sum of money plus a return for the use of that money over the term of the repo.

The repo market refers to the market for short-term borrowing for dealers in government securities. The dealer sells the government securities to investors, usually on an overnight basis, and buys them back the following day.

The Personal Consumption Expenditures (PCE) Price Index is a measure of price changes in consumer goods and services; the measure includes data pertaining to durables, non-durables and services. This index takes consumers' changing consumption due to prices into account, whereas the Consumer Price Index uses a fixed basket of goods with weightings that do not change over time. Core PCE excludes food & energy prices.

The unemployment gap is defined as the difference between the nonaccelerating inflation rate of unemployment and the actual unemployment rate.

The Bloomberg Barclays High Yield Energy Index and Bloomberg Barclays High Yield Ex Energy Index  measure the return, spreads and yields of the below investment-grade debt of companies both in and out of the energy industries.

Option-Adjusted Spread (OAS) is a measure of risk that shows credit spreads with adjustments made to neutralize the impact of embedded options. A credit spread is the difference in yield between two different types of fixed income securities with similar maturities.

One basis point equals one one-hundredth of one percentage point.

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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