THE REAL TEST

By admin | February 28, 2008

CNNMoney calls it a “high wire act.” BusinessWeek says Bernanke “faces stiff headwinds.” And Allan Meltzer in today’s Wall Street Journal asks if the Fed has “reverted to its mistaken behavior in the 1970s?”

The immediate source of the sobering commentary is yesterday’s chit chat between the House financial services committee and Fed Chairman Bernanke, who emphasized that the central bank is focused on the softening economy, by which he means that inflation fighting is of secondary import, at least for now. Suffice to say, that’s a provocative idea with inflation on the rise. In any case, it’s clear that more interest rates cuts are coming, a prospect that helped the dollar sink to new lows against the euro and raise questions anew about the future of inflation in these United States.

“The continued focus on the weak growth outlook supports our view that the Fed will cut rates by 50 basis points - when it meets on March 18 - and will continue to cut rates beyond that in order to limit the downside growth risks,” Drew Matus, economist at Lehman Brothers, told the Financial Times today.

Hardly anyone disagrees, although not everyone’s celebrating. “Bernanke has really overweighted the economic risks relative to inflation,” John Silvia, chief economist at Wachovia Corp. explained in a Bloomberg News story. In fact, “he may get some disagreement” among colleagues on the Federal Open Market Committee, Silvia speculated.

The disagreement, of course, is whether the Fed’s planting the seeds for higher inflation. That’s a debate that will be ongoing for some time because a definitive answer one way or the other won’t arrive for months, perhaps years.

But for the moment the Fed is likely to keep cutting for two reasons. One, the economic reports continue to reflect weakness, and so the perception that the country needs more economic stimulus is now widespread. Two, the bond market is still on board with the Fed’s game plan. When one or both of these factors reverse, the proverbial jig may be up and the central bank may be forced to hike rates, perhaps sharply and quickly.

For now, Bernanke can keep pushing rates lower without fear that inflation expectations are soaring. One measure of the market’s outlook for inflation is measured by the breakeven rate, defined as the spread in the nominal 10-year Treasury yield over its real yield in its inflation-indexed counterpart, a.k.a. the 10-year TIPS. By that standard, inflation expectations haven’t changed all that much from the perspective of recent history. Then again, those expectations have recently turned up.

Note that the last data point in the above chart is through yesterday, February 27, which closed with an inflation expectation of 2.4%. That’s middling by the standard of the last four years, and so the Fed may still have room to lower interest rates without sparking worries that it’s letting inflation momentum build. And as a number of studies over the years remind, managing inflation expectations is crucial to keeping a lid of prices generally.

Still, no one should assume that inflation expectations can’t rise quickly. Recall that in mid-2003, inflation expectations were running at 1.6%, according to the nominal/TIPS yield spread; by early 2004, the market was anticipating inflation at over 2%, a prediction that rose as the year rolled on, hitting 2.6% by May 2004.

For good or ill, the Fed watches this measure of inflation expectations closely, said Larry Kantor, head of research at Barclays Capital in New York. He spoke yesterday at a press briefing attended by this reporter and other journalists. As a former economist with the Federal Reserve Board, Kantor knows a thing or two about how the central bank operates. As such, we were all ears when Kantor advised that “the real test is if the breakeven [rate] moves up.”

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