On the Fed’s New Inflation Threshold

In this week’s commentary at Hussman Funds, fund manager John Hussman comments on the Federal Reserve’s recently announced inflation threshold that, along with their new unemployment target, changed the way they communicate with the rest of us regarding monetary policy.

Recall that the policy committee said they would keep interest rates freakishly low (my words, not theirs) so long as “the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored”. Here’s Hussman:

Inflation expectations are typically inferred using the difference between nominal interest rates and the real interest rate on inflation-protected securities of the same maturity. Since nobody at the Fed actually seems to be tracking long-term inflation expectations, the following chart shows 10-year inflation expectations implied by the difference between the 10-year nominal Treasury yield and the yield on the Treasury Inflation Protected Security maturing closest to 10 years from today.

Notice that the 10-year expected rate of inflation abruptly spiked past 2.5% months ago. The precise date of that spike? September 13, 2012 – the day that Ben Bernanke announced QEternity. At present, the 10-year TIPS yield is -0.70%, meaning that investors are paying for inflation protection by pricing the bond at a negative real interest rate. This compares with a yield of 1.86% on the 10-year nominal Treasury, implying a 10-year inflation expectation of 1.86 – (-0.70) = 2.56%.

The upshot is that further quantitative easing became inappropriate on precisely the day that it was announced. The Fed has already successfully destabilized inflation expectations not for two years, but for the next decade. So much for “anchoring” long-term inflation expectations.

Does that mean this recklessness will stop? Probably not.

I shared my thoughts on this subject last month in The Fed’s New, Squishy Inflation Target and it seems clear to me that they’ve left themselves plenty of wiggle room if and when they ever succeed in generating higher levels of economic activity that, most likely, will be accompanied by higher inflation.