Bernanke, Fed Inflation Expectations and Dueling Mandates
The Federal Reserve claims that inflation expectations are being held in check, but how does it know? It has mucked about using QE in the bond market and engaged in operation twist, an attempt to make long-term rates lower. These very actions muddle the signals in the yield curve. So how does the Fed even know that inflation expectations are still in check? How do we know, and who do we trust?
Bernanke has been Fed chairman for about six years, since February 2006. During this period he has sought to implement an inflation target. Early in his tenure he tried to institute a target but with political pressure opposed to it he stepped back, instead opting to use the Fed's long run forecasts as representing the Fed's goals or targets as guideposts. His first idea was to target a 2% rate in the core PCE, but in January of 2012 the Fed formally adopted a 2% headline PCE as the benchmark most consistent with the Fed's dual mandate. Still, the Fed's formal adoption of an inflation guideline is not the seminal event it may seem.
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The Fed adopted the inflation guideline along with a formalization of an unemployment objective. The unemployment objective is not fixed. It is pliable. Yet the Fed tells us the objectives or mandates for unemployment and inflation have equal standing.
Good news/bad news? This review rehashes where the Bernanke Fed has taken us. It is not clear to me that we are any better off with a stated objective for inflation than with a subtle declaration when the cost of the formal objective is that it shares first-line status with an unemployment rate objective that will undermine it and may dominate it at times-at the wrong times.
Given the new limitations, it is hard for us to test to see what the markets think of this new policy. While the Fed asserts that inflation expectations are well behaved and under control, the Fed has purchased massive quantities of bonds in its QE operations, and through Operation Twist it has distorted market signals. These are now key limitations that have destroyed the value of important market benchmarks.
Since the Fed is trying to affect long term rates with policy, the yield curve and the TIPs-to-Treasury spreads are no longer valid measures of market inflation expectations. They are the contrived results of Fed policy. So when the Fed says that inflation expectations are still low, how do we know it's true - how does the Fed know?
To explore that, we want to look at a survey of inflation expectations. We have plotted some select U of M data in chart form. It features one-year and five-year expectations plotted along with oil prices, the index for West Texas Intermediate oil. The chart shows that the one-year expectation is more closely tied to oil than is the five year expectation.
In trying to figure out if the Fed's new policy has issues as far as its credibility on inflation, we must try to isolate the impact of oil prices on expectations, since they also have been in flux.
The table looks at one-year and five-year inflation expectations and their relationship to oil prices before and after the oil prices shock of May-Sept 2008. We look at four measures: (1) the low 25 percentile expectation, (2) the high 75th percentile, (3) the median expectation and (4) the mean expectation.
One year expectations show generally higher correlations with inflation for the period after the oil Price shock compared to before. One year expectations also show higher correlations with oil prices both before and after the shock compared to five year correlations. But five year inflation expectations do not show much correlation between oil prices and inflation either before or after the shock; the correlation is generally lower after the shock.
With that summary we see that oil prices have a larger impact in one-year inflation expectations. The fact that after the oil shock the 5-Yr correlation with oil prices went down suggests that either prices are now up at a level that participants expected, so no further impact on inflation is expected, or that the Fed handled the oil shock so well that the market no longer fears oil price bulges as much as it once did.
On the other hand, the higher one year correlation says, in the short run, markets are more sensitive to what oil prices can do to inflation in the coming year. Still the lower 25 percentile (of both measures) is still the most sensitive to energy price increases. The high 75th percentile group sees very little impact on expected-inflation from oil prices. The same is true for median and average prices.
Yet over the past two months as the Fed adopted its new policy both one-year and five year median inflation expectations are up in the top ten percentile and fourteenth percentile of their respective ranges when compare to the past six years of data. Two months is too short a period to know for sure what this mini surge means. But oil prices are no longer having such a big impact as they are moving sideways.
Moreover, much of their impact on expectations has been dulled as the oil price climbed, as we demonstrated above. Still, since the Fed adopted its new mandate in January, and since then inflation expectations are rising for both one-year and five-year horizons. Is this concern about the new mandate?
Since we can't use our usual market relationships to detect inflation expectations from the yield curve or TIPS spreads, we have used the inflation survey directly. We have tried to isolate and understand the impact of oil which does not seem to loom large at the moment. The recent move in inflation expectations may have to do with the market not being reassured by the Fed's new format: an unclear promise with a clear caveat and precise number of unknown importance.
Sum Up: While the Fed is telling us 2% on the PCE is consistent with its mandated charge for price stability. Still, it is not engaging in price level targeting. That means it does not promise that from here on out inflation will be 2% or less. So what does the 2% mean? We do not know. With a second objective on unemployment investors may be wondering exactly what the Fed will do; where it will draw the line in pursing objective #2 at the cost of objective #1. And we think that is a reasonable thing to worry about since the Fed Chairman has made it clear that his objective is more growth and to not take his foot off of the gas too soon.
So, it is not surprising that markets are less sure of what the Fed is promising even though Fed enumerated its promise in late January statement, especially since in doing so the Fed only made things muddier. We know that in his first five years Bernanke sought to keep core inflation at 2% and did a good job of it; now his mandate is more complicated. Is it also less credible?