What Is the FOMC Going to Do?

 |  Includes: IEF, IPE, STIP, TBT, TIP, TIPZ, TLT
by: Zhong Jin
Among the reasons for QE2 is the promotion of employment and an increase in inflation back to 2%, according the November FOMC statement. After a month, the Fed partially achieved these goals. Inflation expectation is up. Yields of 5-year Treasury notes (78 bps) and 7-year Treasury notes (77 bps) saw the largest increase in the past month.
Chart 1: Yield Curves of 11/3/2010 and 12/13/2010
Click to enlarge
(Click charts to enlarge)
December Treasury note and bond auctions also see yields rising. Furthermore, while commodity prices are rallying due to QE2, inflation rates in emerging economies such as China are spiking, which implicitly increases production costs in emerging economies.
Chart 2: Auction Yields of 10-year Notes and 30-year Bonds in 2010
Click to enlarge
The recent US economic data also painted a rosy picture. Except for the poor nonfarm payroll number, almost all other indicators including PMI, consumer confidence and trade balance, showed that the US economy is improving steadily and strongly. That should give FOMC enough room to wait and see, for now, if employment will follow the lead of other indicators. However, as I have argued several times before, when the growth rates of commodity prices outpace those of consumption and consumer prices, employers will be hesitant to add more jobs to protect their profits. That means that the Fed’s program will fail to achieve the goal of lifting employment. In another few months, the Fed will have to examine its tool box to see what else can be done to boost economy. The extension of QE2 or even QE3 will be in the play at that time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.