On Fed tightening, again

Posted by Cardiff Garcia on Jun 21 18:08. Comment | Share

Ahead of tomorrow’s FOMC statement and press conference, your (US) inflation graphs du jour:The graphs show the findings of MIT’s Billion Prices Project (BPP), plotted against the latest CPI numbers through the beginning of June. More…

Ahead of tomorrow’s FOMC statement and press conference, your (US) inflation graphs du jour:

The graphs show the findings of MIT’s Billion Prices Project (BPP), plotted against the latest CPI numbers through the beginning of June.

As a measure only of online retailer prices, the BPP isn’t meant to track the all-items CPI. But we’re reporting it here both because it’s an interesting new data point and because the two indexes are now showing that inflation has moderated lately.

We mentioned after the recent CPI numbers that it was exceedingly unlikely that the Fed would be pursuing QE3 anytime soon.

The idea isn’t that inflation is anywhere near levels that, historically, would be considered worrisome — it isn’t. And we’re not making a case here for whether or not the Fed is right to think that way, only reinforcing the point that the inflation environment is drastically different from where it was last year before QE2 was enacted — and core inflation has been climbing steadily to the point where the Fed probably doesn’t feel that further unorthodox easing would be wise.

Here’s a recent chart from Credit Suisse:

But (here comes the pivot) what we did not say after the CPI numbers, mostly because we didn’t think it necessary, was that we think it’s at least equally as unlikely that the Fed will even consider tightening anytime soon, especially given the recent disappointing unemployment numbers.

But some apparently disagree. On Monday, Marketbeat spotted analyst notes from both BarCap and UBS saying that the Fed was likely to begin worrying about inflation sooner than the market was predicting (emphasis Marketbeat’s):

Meanwhile, here’s UBS, led by Maury Harris, going a step further:

Market participants are pondering the relative importance of the recent soft patch versus the recent run-up in core inflation in the Fed’s thought process. We believe the Fed is currently more focused on the inflation half of its dual mandate.This view, coupled with our expectations of a rebound in second-half growth following the “soft patch”, continues to suggest the Fed will move earlier than the consensus expects—we look for the first increase in the Fed funds target rate in January 2012.

This is not at all what the fed-funds market expects. That market doesn’t expect the first rate increase until the second half of 2012.

And for good reason: Even UBS’s CPI forecast, just raised today, sees core CPI coming in at 1.9% in 2011 and 2.1% in 2012. This is not the stuff of runaway inflation.

We’re with Marketbeat on this one, and here’s a snapshot from Bloomberg showing the implied probabilities for tightening at each of the FOMC meetings starting next year:

(These probabilities are extrapolated from the trading of fed funds futures on the CBOT.) The first FOMC meeting on which the market predicts more than a 50 per cent chance of tightening is on November 24, 2012. As for the January 2012 meeting, it’s only estimating a 17 per cent chance of tightening.

And inflation expectations, both the market-based measures and those generated from consumer surveys, have declined in recent months. We’ve said just about all we wish to on the conceptual underpinnings, and problems with, the various approaches. What we know is that the Fed watches them carefully, and that they’ve clearly been trending downward.

Look, the market gets these things wrong all the time, and these implied probabilities shift along with broader macro trends. (Last December, for instance, futures were predicting that the Fed would begin tightening by this August.) So we realise that it’s best not take any of this too precisely. For all we know, maybe commodities prices will resume climbing in the second half of the year, or the economy will (somehow) unexpectedly improve and inflation will ramp up, changing the Fed’s calculus. Or not.

We have no idea, but for now we’re expecting the Fed to stay on hold — and any meaningful signal that it is leaning one way or the other would come as quite a surprise to us.

Related links:
A CPI reversal of sorts – FT Alphaville
Deflated inflation expectations – FT Alphaville
Two more views on inflation expectations – FT Alphaville
“Transitory” in two graphs – FT Alphaville
When will tightening begin? – FT Alphaville
Tightening: not when, but how fast
– FT Alphaville

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