When Will The Fed Tighten? Watch Inflation Expectations

Includes: DIA, QQQ, SPY
by: Bill Conerly

When will the Federal Reserve tighten? Let's watch the same information that the Fed does. In their parlance, the plan is "data dependent." The recent Wall Street Journal interview with Bill Dudley, President of the New York Federal Reserve Bank, underscores the point.

In a previous post, Think The Federal Reserve Has A Plan? Not Exactly, I described it this way:

"The Fed has a rough outline of a plan. Within their own policy-making committee, they are divided. They have come to an agreement about current policy. The consensus behind this rough outline of a plan is weaker. The Fed official giving a speech will not tell you what policy will be two months from now because he or she truly does not know. The Fed will look at the data that comes in. They will decide whether or not to keep that old rough outline of a plan. If they keep it-which is not guaranteed-they will then decide what the latest economic data mean for the implementation schedule of the plan."

So just what information would lead the Fed to change its plan and tighten earlier? First, if economic growth is much stronger than expected, that would be a major factor. We're not talking about one quarter in which a major portion of the growth was a reaction to a prior quarter being weak. They will want to see that it's solid, sustained growth. Their problem, however, is that they don't dare wait too long.

The second factor they will look at is actual inflation, but that's difficult to judge. Energy price shocks, and sometimes food price changes, make the inflation numbers hard to interpret. Further, inflation tends to reflect past pressures rather than the current economy, so the Fed will want to delve into the cause of any rise in inflation.

The third factor, and one mentioned by Dudley in his interview, is inflation expectations. This is the one that they will watch closely and take seriously, and it's not followed too much by the average corporate executive. However, if inflation expectations take a significant jump, that will probably trigger a tightening by the Fed.

Widely accepted economic theory says that higher inflation expectations will trigger wage and price increases. If the economy is not strong enough to justify those price increases, then sales will fall. If the economy is strong enough, then we obviously get inflation. Thus, expectations of inflation have an important role in the economy separately from actual inflation.

Measuring inflation expectations is a little tricky, with two key approaches. The first looks at the difference between the yields on ordinary Treasury bonds and the yields on inflation-adjusted bonds. That difference is expected inflation. Right now, the spread is 2.2 percent, a pretty reasonable estimate, and down from a year ago's 2.6 percent.

A survey of inflation expectations is another approach. One great example is the Survey of Professional Forecasters conducted by the Federal Reserve Bank of Philadelphia. The median response to the question of the 10-year inflation forecast was two percent, pretty close to the interest rate calculation and steady from a year ago.

Another branch of the Fed, the Federal Reserve Bank of Cleveland, has created a broth of both interest rate and survey data, and that's the easiest way for a non-economist to take a look at expected inflation. They have a link to subscribe to a free monthly update. Their measure is running slightly below two percent, but has risen two-tenths of a percent in the past year. Measuring in tenths is probably imputing too much accuracy to the estimate.

Rolling all of the data together, market participants seem to expect about two percent inflation. There's a chance that average consumers and workers are expecting more, and we don't have great measures of popular attitudes. There's evidence that consumers frequently overestimate inflation, which could lead to expecting too much in the future.

The good news is that despite some fears of the Fed's quantitative easing, neither inflation nor expected inflation have risen. However, watch expected inflation closely, because it will probably give you the first inkling of the Fed's move to tighter monetary policy.