It is well understood that while the Federal Reserve is succeeding in the employment part of its dual mandate, it is significantly undershooting the inflation part. The market certainly reflects this. The question is: Will the Fed listen to the market?
The Fed’s target for Personal Consumption Expenditure (PCE) is an increase of 2% per year. Yet the most recent year-on-year reading for headline PCE inflation is 0.3%. For core PCE, which excludes the volatile food and energy components, expansion is 1.2%.
The Fed justifiably looks through the low headline numbers, attributing them to the sharp drop in oil prices. Perhaps more troublesome are the persistently low numbers for core PCE. While the Fed acknowledges this, it emphasizes the falling unemployment rate and the role of stable inflation expectations to provide “reasonable confidence” that inflation will return to its 2% target in the medium term. Vice Chairman Stanley Fischer discussed this in his August 29th speech at Jackson Hole when he (circuitously) cited the survey of Federal Open Market Committee (FOMC) participants – they project core PCE between 1.9% and 2.0% in 2017 – as an example of stable inflation expectations.
Markets paint a very different picture for future inflation. The best market-based measure of inflation expectations can be determined by comparing yields on Treasury Inflation-Protected Securities (TIPS) to those on nominal Treasuries. While there are known issues – TIPS are indexed to headline CPI, and the difference in yields may include liquidity and other risk premia in addition to inflation expectations – we conduct three basic steps to derive the market’s implied estimate for core PCE:
- Estimate risk premia embedded in the spread to convert the spread into inflation expectations for headline CPI.
- Use prices implied by futures for gasoline and other commodities to turn an expectation for headline CPI into one for core CPI.
- Estimate a steady-state difference between CPI and PCE. Our estimate is that CPI averages 0.35% per year higher than PCE.
Putting all this together, and sparing you the math, the market implicitly estimates that core PCE will average below 1% per year over the next five years! And there you have a conundrum. Either the Fed is correct and inflation will reach its 2% target by 2017 (in which case TIPS are a screaming buy relative to nominal Treasuries) or the TIPS market is correct. If the latter is the case, then inflation is so unlikely to return to the Fed’s target in the medium term that the FOMC should not even be contemplating a hike in policy rates.
We think the truth lies somewhere in between. The healthy U.S. economy and job market should start to raise inflation and inflation expectations above today’s extremely low levels. In fact, we expect core PCE to rise to about 1.65% over the next several months. However, we think the Fed should acknowledge the signal markets are sending. In fact, it is possible that the current equity market volatility and subsequent tightening of financial conditions is a result of the Fed choosing to downplay these market-based inflation expectations.