Last week the Federal Reserve surprised the markets with a 50-basis point cut in the Federal Funds rate target, which is somewhat larger than the market anticipated. The Fed cited, “the tightening of credit conditions” and the potential for these conditions “to intensify the housing correction and to restrain economic growth more generally” as justifications for their move.
Much like Monday morning quarterbacks, market commentators are predicting dire consequences from the move, stating it was “too aggressive.” One market-watcher is quoted saying the Fed moved, “much too quickly and that’s going to cause some kind of inflationary reaction.”
There may be legitimate disagreement about whether the 50-basis point cut was too much or too little. However, on the question of how the cut is expected to affect inflation, there’s little disagreement. Simply put, the market believes the move will have a relatively small impact on inflation. Alternatively put, the commentators are distorting the facts.
I can confidently make this claim by looking at what the market did on the day of the Fed announcement. Specifically, by comparing yields on Treasury Inflation Protected Securities (TIPS) to non-inflation protected Treasuries of a similar maturity; it’s possible to determine the best guess of market participants. Since market prices move all the time for a multitude of reasons, only by comparing otherwise identical securities can we back out how the announcement affected inflation expectations.
Let’s be specific with a back-of-the-envelop calculation. On the day of the announcement, the difference between the yields on the 5-year constant maturity Treasury and the 5-year inflation-protected constant maturity Treasury was 2.1 percent. That implies the market expects inflation over the next 5-years to be roughly 2.1 percent. On the day before the announcement, that difference was 2.08 percent. Thus, the Fed’s surprise move raised inflation expectations by 2 basis points. Just for comparison, since August 1, 2007 there have been 17 days with changes at least as large, 5 days with a 3-basis point change, 1 day each with a 4-point and 5-point change, and 2 days with a 6-basis point change. So, despite all the commentary, the day’s change seems pretty unremarkable.
There’s still the question of whether we’re in a position to accommodate a 2-basis point increase in inflation over the next 5 years. Inflation in the United States is currently historically low, at around 2 percent (measured either using the CPI or the CPI less food and energy.) It’s roughly what it was when George W. Bush came into office and at least 3 percentage points below what it was at the beginning of the Clinton administration. It’s also been trending down in the last several months, so there seems little cause for alarm.
I suspect this is just another case of upset bond traders. The difference between Monday morning quarterbacking and commenting on monetary policy is that the commentators can affect the game (oh, I mean the economy,) whether their views should be taken seriously or not, because the market response becomes relevant for the next play. At least in this case, the commentators should have checked their facts first.