In the December 19, 2012 article, “What the Fed’s New Policy Means For Bond Investors,” Learn Bonds offered insights on what different types of inflation and unemployment trends would mean for investors. The article highlighted four possible scenarios: low inflation and high unemployment, low inflation and low unemployment, high inflation and high unemployment, and high inflation and low unemployment. I would like to dig a bit deeper into two of them.
The Fed is now providing inflation (2.5%) and unemployment (6.5%) guideposts for determining future policy. And I think the guideposts will be the root of future misinterpretations by investors. This is especially true under these two scenarios:
Low Inflation and Low Unemployment – If the unemployment rate gets much closer to 6.5% than it is today, I have a hunch you will see the bond market begin to price in the expectation of rate hikes by the Fed, largely ignoring the inflation side of the equation.
High Inflation and High Unemployment – If inflation suddenly takes off, I have a feeling financial market pundits will begin to discuss the strong likelihood of Fed rate hikes.
In both of these scenarios, investors jumping to those conclusions without considering other important factors in the Fed’s decision-making process will be opening themselves up to being on the wrong side of the correct trade. In the December 12, 2012 press release issued by the Fed, the following was said:
“In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. The Committee views these thresholds as consistent with its earlier date-based guidance. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.”
The aforementioned statement by the Fed gives credence to the following assumptions:
1. If the unemployment rate declines to 6.5%, but inflation is below 2.5%, the Fed will not necessarily raise rates. The words, “at least as long as” from the Fed statement are key to this assumption. Additionally, note that the Fed says it will also consider other information, such as “additional measures of labor market conditions,” when making a decision on monetary policy. This is extremely important to remember. The reasons for the decline in the unemployment rate will be considered by the Fed. If the drivers of lower unemployment are a decline in the labor force and part-time jobs (certainly not out of the question), then the Fed will likely remain on hold, even if the unemployment rate drops below 6.5%. But as the unemployment approaches 6.5%, I think price action in the bond market would indicate rate hikes are on the horizon. And that would provide an investing opportunity for fixed income investors.
2. If inflation rises to above 2.5%, but the unemployment remains stubbornly high, investors, depending on how high inflation rises, may begin to wonder whether the Fed will raise rates, pushing yields across fixed income markets higher. And that would also likely provide an investing opportunity. This is for two reasons. Given today’s political realities, I think the odds are incredibly low that the Fed raises rates with unemployment above its 6.5% guidepost. I know Fed decisions are supposed to be made independent of political considerations, but that’s not the feeling I get from following the Fed in recent years.
Additionally, as noted in the aforementioned press release, additional factors will shape future Fed policy, including “indicators of inflation pressures.” In recent years, the Fed has not hesitated to call any uncomfortably high inflation we’ve seen “transitory.” As long as wage growth is anemic and inflation is stemming from traders pushing commodity prices higher, I think the Fed will stick to its “transitory” stance of commodity futures induced inflation. There are other ways to handle inflation stemming from rising financial asset prices than having to raise rates. Hefty margin hikes could do that job instead. And while the Fed itself can’t hike margins, I think investors would be wise to consider the interconnectedness of financial and political institutions and their willingness to do what they believe is necessary to meet their objectives.
As you watch incoming economic data over the coming years and attempt to figure out how the Fed will respond to such data, don’t forget to look beyond the inflation and unemployment guideposts provided by the Fed and consider such things as the underlying drivers of movements in inflation and unemployment data. Things such as wage growth, the quality of the jobs being created, and the reasons for inflation are all important considerations in your analysis. One additional factor not mentioned in this article but also worth keeping in mind is the long-term fiscal problem facing the U.S. government. Without a solution to that problem, the Fed will be hard-pressed to stop its unconventional monetary policy for any significant period of time.
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