Global Macro: Inflation Indicator Falls Ahead of Fed Meeting

TheStreet.com

NEW YORK (TheStreet) -- Expectations for greater inflation are drifting lower ahead of Wednesday's Federal Reserve policy decision.

One inflation indicator is iShares TIPS Bond over iShare 7-10 Year Treasury . The indicator measures the market's expectation for future inflation based on the strength of bonds that track a basket of consumer prices, compared with a normal Treasury bond index.

When the indicator moves higher, it signals that the market is pricing in greater inflation. When it declines, it signals the market is pricing in a deflationary environment.

Last June, the pair reached its bottom, weeks after Fed Chairman Ben Bernanke hinted that the Fed would begin to cut stimulus. Financial markets were relying on loose central bank policy, and any suggestion of a tighter policy led to a panic that interest rates would rise sooner than expected.

Since 2012, inflation readings have been consistently below the Fed's 2% target. The possibility of a rate increase turned the focus to possible deflation, pushing already low inflation even lower.

Since the financial crisis, economic data have steadily improved due in part to increased stimulus, but consumer prices have failed to rebound as quickly.

Over the past few months, economic growth has remained gradual, and the labor market has produced mixed results. It will take much more improvement on both fronts for consumer prices to trend higher. A gradual recovery can keep markets happy for only so long.

The TIPS inflation indicator shows that the sudden drop in the pair may have been an overreaction, but that the overall trend of lower inflation is correct. The indicator has continued to drift lower since late August, even though the Fed didn't cut bond purchases till its December meeting.

Many analysts believe more stimulus cuts will come this year, which could continue to weigh on the indicator. The TIPS indicator could decline significantly this Wednesday if the Fed cuts quantitative easing to an expected $65 billion a month.

If the Fed keeps its bond purchases at $75 billion a month, it is hard to see the indicator spiking that much higher, considering cuts may come in the following months.

Ultimately, it is going to take a strong push from both economic growth and an improved labor market this year to get prices in the economy moving higher again.

TIP Chart
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At the time of publication, the author had no position in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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