REUTERS/David W Cerny
Philadelphia Fed President Charles Plosser
BofA economist Ethan Harris has been adamant in recent months about the slowdown in inflation and what it means for Federal Reserve monetary policy.
Harris believes it skews the risks of more monetary stimulus to the upside – after all, despite criticism of the Fed's quantitative easing program and its effect on bond markets, the central bank is still undershooting its nominal targets on both the inflation and employment fronts.
In other words, as long as the annual inflation rate stays below the central bank's 2% target, it puts more pressure on the Federal Reserve to continue buying up Treasury and mortgage bonds
Over the past two weeks, speeches from various regional Fed presidents who tend to take a hawkish policy stance – and articles from Wall Street Journal Federal Reserve reporter, Jon Hilsenrath, who is known for his access at the Fed – have shifted the conversation toward the possibility that the central bank will begin tapering down its stimulus soon.
Against this backdrop, there's been a significant back-up in interest rates in recent weeks as the bond market contemplates what sort of effect reduced buying from the Fed would have.
Harris asserts in a note to clients that "comments by FOMC hawks still get undue attention in the markets and the financial press," specifically calling out Philadelphia Fed President Charles Plosser:
The wrong man: Bond markets have been on edge since the start of the year, trying to figure out when the Fed might scale back its QE3 purchases. Despite their limited role in the policy making process, comments by hawkish FOMC members still appear to get undue weight by the markets.
Good recent examples were comments by Philadelphia Fed President Charles Plosser, both for a Wall Street Journal article and in speeches in Europe. Plosser’s calls to start tapering QE3 in June are likely to fall on deaf ears, in our view, as his reasons for wanting to scale back the Fed’s asset purchases are not generally shared by his Fed colleagues.
Plosser is not a voting member on the FOMC this year. Dovish Boston Fed President Eric Rosengren, on the other hand, is a voting member, " and he has been a much better barometer of Fed policy actions than Plosser," says Harris:
Plosser dismissed the recent data, noting inflation has been close to 2% over the past three years. “Should inflation expectation begin to fall,” he said, “we might need to take action to defend our inflation goal.”
Rosengren took the opposite tack: “the longer we in the US remain so far below our 2 percent target, the greater the risk that inflation expectations could fall.” As we discuss in our Macro Viewpoint this week, this seems to be the greater risk. And it is increasingly likely to preoccupy the majority of Fed officials until inflation rates rebound.
(Hilsenrath disagrees with this argument. He wrote in a WSJ blog post yesterday that the FOMC isn't "ringing the alarm bells" over inflation yet because of quirks in the way the inflation indices are computed.)
That all makes sense, even though bond markets seem to be taking threats of Fed tapering pretty seriously in recent trading sessions.
But Harris goes on to completely eviscerate the hawkish argument for Fed tapering:
First, it seems inconsistent to be confident that inflation will rise back to 2% due to anchored expectations, yet see a high risk that inflation expectations will become unanchored to the upside. Why is the public supposed to have full faith that the Fed can increase inflation but not that it can reduce inflation? Are inflation expectations anchored to “two percent or higher”?
Second, the anchored expectations argument is too parsimonious to explain recent movements in inflation. If inflation expectations are really that powerful, why did inflation cycle up and down over the last two years? In our view, a sensible forecast should acknowledge that global commodity and labor costs boosted inflation in 2011 and have been reducing inflation ever since. We also think continued economic slack—a 7.5% unemployment rate, and weak global growth—should push down inflation.
Third, and more fundamental, the hawks seem to assume that the general public forms inflation expectations the same way they do. People allegedly see that bank reserves are unusually high, pull out their undergraduate money and banking textbook, and conclude that the reserves will inevitably cause a multiple expansion of lending and spending. In the jargon of economics, this is an example of a “rational expectations” model, in which the economic actors form expectations about the future using the same model as the economist...
This leads to our fourth argument: inflation expectations could fall as well as rise. Indeed, economists at the Cleveland Fed argue that if inflation breakevens are properly adjusted, inflation expectations have already fallen below target.3 Keep in mind that the gap between nominal and real treasury yields is, at best, a very rough gauge of inflation expectations. The gap is impacted by the relative liquidity of the two markets as well as a variety of uncertainty or risk premiums. For example, during the financial crisis, inflation breakevens collapsed in part due to lower inflation expectations, but mainly because investors piled into the safe, highly liquid nominal treasury market, causing a huge liquidity premium.
That's why Harris isn't listening to the hawks.
Federal Reserve Chairman Ben Bernanke and New York Fed President Bill Dudley, on the other hand (considered to be two of the three most important voices on the FOMC, along with Vice Chairman Janet Yellen) are hitting the tape early next week.
"We see two things to watch for," says Harris: "hints of concern that inflation is too low and confirmation that the Fed has the flexibility to increase as well as reduce the pace of QE."
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