The Federal Reserve indicated heightened concern about inflation today, responding appropriately to recent signs of accelerating inflation and inflation expectations.
The Fed did not indicate that more aggressive actions were on the immediate horizon, but today's policy statement increases the probability of either more aggressive rate actions a few months from now, or a larger amount of cumulative interest rate hikes.
Historically, any expression of concern shown by the Federal Reserve with respect to the inflation outlook has been met with rising interest rates in the bond market. The fact is, the Federal Reserve's mandate is to control inflation. So when the Fed indicates, as it did today, that the inflation rate is on the rise, there can be only one conclusion: The Federal Reserve will respond to the inflation threat by raising interest rates as much as is necessary to maintain price stability.
There are several notable changes to the policy statement delivered today by the Federal Open Market Committee, most of which carry negative short-term implications for the Treasury market and could continue to put upward pressure on credit spreads, adding to recent pressures related to developments at
Here's a comparison of today's FOMC statement with the Feb. 2 FOMC statement:
Feb. 2: Inflation and longer-term inflation expectations remain well contained. March 22: Though longer-term inflation expectations remain well contained, pressures on inflation have picked up in recent months and pricing power is more evident. The rise in energy prices, however, has not notably fed through to core consumer prices.
The Federal Reserve's sanguine outlook on inflation was updated to reflect the recent jump in inflation indicators and in inflation expectations. When the Fed met in February, for example, the yield on the 10-year was hovering around 4% and the yield spread between the Treasury's 10-year inflation protected securities and conventional Treasuries was at a four-month low of about 2.5%, indicating that expectations were for the consumer price index to post increases averaging 2.5% over the next 10 years. Now the spread is at an all-time high of 2.8% (dating back to January 1997), indicating that inflation expectations have increased. Adding to recent concerns have been sharp increases in producer prices and a 0.3% gain in the deflator for personal consumption deflators, which was the fastest pace of gain in more than two years in the Federal Reserve's key gauge on inflation.
Feb. 2: The Committee perceives the upside and downside risks to the attainment of both sustainable growth and price stability for the next few quarters to be roughly equal. March 22: The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal.
Whereas in February the Federal Reserve indicated that it believed inflation risks were inherently low, the Fed is now indicating that if these risks are to be "kept" low that it will require actions from the Federal Reserve.
Feb. 2: With underlying inflation expected to be relatively low, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. March 22: With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.
Looks the same? Look closer. Previously, the Fed said that inflation was expected to be "relatively low." Now the Fed is saying that it is expected to be "contained." The difference is significant because the Fed is no longer characterizing the inflation rate as low. Also, the Fed is again indicating that its actions will be needed to keep inflation contained.
As a result of today's policy statement, expectations for future interest rate hikes have increased. The market is now priced for 40% odds that the Fed will raise interest rates by a half percentage point at the June 30 FOMC meeting and, for the first time, the market is priced for the federal funds rate to end 2005 over 4%.
The Fed's show of resolve is bearish for Treasuries in the short run, but more aggressive actions will ultimately reduce the risk of a breakout in inflation and hence help to contain a breakout in interest rates. Nevertheless, as I recently stated, interest rates will continue to rise until either financial conditions tighten significantly further or, less likely, the economy shows signs of slowing.
Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of
The Strategic Bond Investor. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy. He appreciates your feedback and invites you to send it to
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