The Federal Reserve Has Fallen Behind The Interest Rate Curve

|
Includes: BIL, CLTL, DFVL, DFVS, DLBL-OLD, DLBS, DTUL, DTUS, DTYL, DTYS, EDV, EGF, FIBR, FTT, GBIL, GOVT, GSY, HYDD, IEF, IEI, ITE, PLW, PST, RINF, RISE, SCHO, SCHR, SHV, SHY, SPTL, SPTS, TAPR, TBF, TBT, TBX, TLH, TLT, TMF, TMV, TTT, TUZ, TYBS, TYD, TYNS, TYO, UBT, UDN, USDU, UST, USTB, UUP, VGIT, VGLT, VGSH, VUSTX, ZROZ
by: Desmond Lachman

Any doubt that the Federal Reserve has fallen behind the interest rate curve should have been dispelled by recent US price and wage inflation data, as well as by the sharp sell-off in long-dated US Treasury bonds. One has to hope that at its meeting this week, the Fed pays due attention to those developments in its setting of interest rate policy. If not, we should brace ourselves for very disorderly financial markets down the road.

There is now no shortage of economic data to indicate that the Fed's 2% inflation target is at risk of soon being exceeded. Core consumer price inflation has risen to 2.1%, while the Fed's preferred inflation measure of core consumer expenditure prices has increased to 1.9%. Meanwhile, wage inflation has picked up to 2.9%, 5-year inflation expectations has risen to 2.2%, and the rise in international oil prices to a four-year high threaten further inflationary pressure.

With inflation already at very close to the Fed's target, unemployment down to practically decade-long lows, and the economy humming along at a brisk pace, the Fed can ill-afford to have the economy overheat. Yet, there is all too great a risk that overheating will occur as a result of still-extraordinarily easy financial conditions and a substantial fiscal stimulus from the Trump tax cut and public spending increases at this late stage in the economic cycle.

The recent sharp increase in US 10-year bond rates to over 3% should be offering a cautionary tale for the Fed. Not only are they signaling that the market is increasingly coming to the view that the Fed's long-term inflation goal is at risk and that the Fed is behind the curve, they are also reminding us that longer-term interest rates are market-determined and risk spiking higher if the market becomes convinced that the Fed is losing control of inflation.

The last thing the Fed can afford is to have long-term interest rates spike higher. If that were to occur, it would all too likely burst today's equity and housing market bubbles, as well as cause a disruptive repricing of credit market risk. For which reason one has to hope that at this week's meeting, the Fed takes a more hawkish stance than it has done to date on interest rate policy with a view to assuring markets that it is still very much in control of inflation.