Sunday, November 11, 2007

Market Stability vs Inflation Expectations

Ever since the Fed officially moved to neutral on Oct 31st, there have been renewed fears that the Fed will allow financial markets to deteriorate rather than cut rates and risk higher inflation.

This trade-off is particularly relevant now, because year-over-year headline CPI is expected to rise over the next several months. Take a look at the graph below. The grey bars are the historical year-over-year CPI rates. The little red bars are the monthly rates. The blue bars are what YoY CPI will be over the next several months if the new monthly CPI numbers come out at a well-contained 2% annualized rate (or 17bps/month). Notice that the YoY rate will trend higher over the next few months, even if the incoming monthly CPI number are low. The actual CPI numbers are likely to be even higher, since the rise in oil prices makes the assumed 2% annualized monthly CPI unreasonably low.

So what should the Fed's immediate focus be: Financial stability or headline inflation risks?

Bill Poole, in a speech last week, came down on the side of market stability:

Concerns that the [Oct 1987] stock market crash might spread to the economy more generally and affect economic growth prompted the FOMC to reduce its target for the federal funds rate by 50 basis points on Nov. 4, 1987. The FOMC cut the target fed funds rate despite the fact that inflation was running at an unacceptably high rate of over 4 percent. The FOMC reduced the target by an additional 30 basis points by Feb. 11, 1988. Once the crisis had passed, the FOMC began raising the target fed funds rate. I have emphasized that the willingness of market participants to take risks is essential to the healing process that restores normal trading in risky assets. When the Fed cuts its target for the federal funds rate, market participants know that the FOMC’s decision at its next meeting will be either to leave the rate unchanged or to cut further. Barring unusual circumstances, the FOMC would not consider a rate increase just after cutting its fed funds rate target. This approach to policy is appropriate when market conditions are fragile because market participants must be confident that they can take positions without the risk that the Fed might raise rates, which would reduce asset values, in the near term. Investors can then concentrate on determining the fundamental value of risky assets and can work on deals to buy such assets from holders forced to sell by their own impaired liquidity and capital positions. As investors accumulate profits from these trades, others are attracted and normal market functioning resumes.
So, according to Poole, the goal of rate cuts during times of market turmoil is to restore confidence sufficiently so that investors are again willing to hold riskier assets. That's problematic for Fed members who don't want to cut rates at the Dec 11th meeting, since markets are expecting a 25bp cut. If they don't cut, the level of risk aversion in the markets will increase, probably significantly. Kevin Warsh, nevertheless, took a more hawkish tone in his speech last week:
There are also important reasons to be concerned about the outlook for inflation. Although recent readings on core inflation have been favorable, prices of crude oil and other commodities have increased. These changes most likely will put upward pressure on overall inflation in the short run. Moreover, the decline in the foreign exchange value of the dollar could lead to higher prices for imported goods. If these same forces cause inflation expectations to become less reliably anchored, then inflation could increase in the longer run as well.
If the Fed could convince market participants of the rationale for focusing on core measures of inflation, they wouldn't have to face this kind of short-term trade-off.  Core PCE inflation is well-known to be a better predictor of future inflation than headline CPI is. This is not even remotely controversial among professional economists. The graph below shows past YoY core PCE inflation plus what the numbers will likely look like in the near future if the annualized monthly rate stays near 1.5%. Clearly there's no imminent inflation problem.

The problem the Fed has is with inflation expectations. Expectations of future inflation can be self-fulfilling and are a very good predictor of future inflation. So if people are going to look at the high upcoming headline CPI prints and decide that inflation is getting out of control, the Fed will be boxed in. They'll have little choice but to raise rates, which would throw lots of people out of work until inflation expectations come back down again. The irony is that core inflation is telling us (reliably) that there isn't an inflation problem; it's only the potential for inflation expectations to get out of hand that's creating the problem. That's why I think it's irresponsible of commentators like Barry Ritholtz to encourage people to focus on headline inflation, and why Mishkin and other Fed speakers need to continue focusing on a communication strategy to break the imaginary connection between non-core inflation and expectations for future inflation.


knzn said...

Obviously I agree with your basic point, but I think you're a bit too optimistic about the impact of food and energy prices. Energy in particular is an input to a lot of other goods and services, so even if everyone were confident in using the core as the target, rising energy prices would still have an inflationary impact. Ideally I would prefer if the Fed could target an index that excludes not just food and energy but also the food and energy content of other goods and services (one reason I like labor cost targeting).

Karl Smith said...

Good post -

My primary concern is about expectations rather than actual inflation. Though I do think the PCE "target" should be 150 bps, implying that we are not looking at a likely undershoot.

However, I am not totally convinced that the Fed can ignore secular trends in commodity prices. While it is true that commodities are volatile and that the core is generally a better predictor, there is reason to believe that some of what we are seeing is a regime change that is likely to continue.

To make matters worse I think that the recent energy moves are probably more transitory than food.