Wednesday, November 10, 2010

Did QE2 Stabilize Inflation Expectations?

The upcoming report on consumer price inflation will help assess whether The Fed made the right move in implementing monetary stimulus aimed at stabilizing inflation expectations. Picerno says that allowing the crowd to anticipate continued disinflation was a major risk. See the following post from The Capital Spectator.

It's all about inflation—or the lack thereof. Next week (Nov. 17) the Labor Department releases its October estimate for consumer price inflation. Economists are forecasting that core inflation rose 0.1% last month, slightly higher than September's flat performance, according to Briefing.com.

The inflation reports in the months ahead will be critical for assessing the severity of the recent disinflation trend and whether the Fed's latest expansion of its monetary stimulus is warranted. Meantime, the trend so far is clear. Core inflation's pace has been steadily falling. Over the past two years, core inflation's annual rate has dropped to 0.9% as of last month, down from the 3% range just before the autumn financial crisis of 2008.



The sharp disinflationary trend is what worries the Fed, and for good reason. At the unusually low levels of core inflation of late (the lowest in half a century), the risk of letting the trend continue is opening the door to outright deflation, or so one school of thought argues. The slippery slope is all the more threatening because the U.S. is also suffering from a hefty debt load.

Has the combination of disinflation and debt sealed the economy's fate? Maybe. We'll have some fresh data to assess next week. Meantime, the market's inflation outlook for the decade ahead is now comfortably above 2%, up from around 1.5% in late-August, based on the yield spread between nominal and inflation-indexed 10-year Treasuries. The summer's decline and fall in inflation expectations has been reversed. What changed the trend?



Arguably the critical factor is the central bank's publicly dispatched plans to engage in a new round of monetary stimulus. The revised strategy began with Fed Chairman Bernanke's August 27 speech in which he explained that even though nominal interest rates were near zero, "the Federal Reserve retains a number of tools and strategies for providing additional stimulus." Last week, the Fed formally annnounced that it would roll out this "additional stimulus."

The goal, as Bernanke has explained, is to stabilize inflation expectations. The risk of letting the crowd anticipate continued disinflation is especially hazardous when core inflation is at 50-year lows and falling. It's an open debate if inflation expectations have in fact been stabilized. For much of the past month, the market's implied future inflation rate, based on 10-year Treasury yield spreads, has remained modestly above 2%. That's not surprising, considering that the annual pace in the nation's money stock is no longer retreating.



But the economy is still weak in a number of key sectors, including housing and the labor market, and so disinflation in the future can't yet be ruled out. Next week's inflation update for October may peel away some of the uncertainty. Meantime, a precarious calm prevails.

This post has been republished from James Picerno's blog, The Capital Spectator.
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