Concern Over Weak Economy Causes Inflationary Expectations to DropAuthor: John MasonLast Updated: September 25, 2014 The Open Market Committee of the Federal Reserve met last week to determine the course of monetary policy. One of the most interesting things to come out of the meeting was the economic and financial projections of the members of the Open Market Committee.Not only did the Federal Reserve officials lower projections concerning the economic growth expected over the next five years or so…they also lowered expectations for future rates of inflation.For several years out, the current range of projections for the price index for personal consumption expenditures ran from 1.7 percent to 2.2 percent. The target range for Fed policy making is 2.0 percent.This is very important for the bond market because of the role inflationary expectations play in determining longer-term bond yields.Right now in the Treasury bond market, the inflationary expectations that are investors have built into the yields are as follows: for five years, inflationary expectations are about 1.8 percent; for ten years, the inflationary expectations are about 2.00 percent.These are extremely low numbers.Inflation hawks within the Federal Reserve System have been very concerned about the large amount of excess reserves the Fed has pumped into the banking system. As of September 17, the banking system had almost $2.8 trillion in excess reserves.The monetary base grew at an annual rate of increase of about 30.0 percent for the six years between August 2008 and August 2014. August 2008 was the month before the Federal Reserve began to accelerate its injection of reserves into the banking system. The excess reserves in the banking system in August 2008 averaged around $11.0 billion…a little less than the $2.8 trillion that existed in August 2014.One of the basic beliefs of the “inflation hawks” is that expressed by the economist Milton Friedman: “Inflation is at every time and every where a monetary phenomenon.”Since so much money was being put into the banking system, these “inflation hawks” believed that the Federal Reserve was creating the conditions for greater price inflation…even the possibility for a hyperinflation.If greater inflation was a real possibility, these officials believed that the Federal Reserve needed to act sooner rather than later to reduce the amount of excess reserves in the banking system and raise interest rates.They also believed that longer-term interest rates should start to rise because of the inflationary expectations connected with the future price inflation that would be coming from having all these excess reserves around.As can be seen from the figures presented above, inflation has not become a problem in the economy as of this time and inflationary expectations as built into the bond market have not yet become an issue.Earlier this week, two of the most prominent “inflation hawks” in the Federal Reserve System resigned. The two individuals were Charles Plosser, President of the Federal Reserve Bank of Cleveland and Richard Fisher, President of the Federal Reserve Bank of Dallas.So, inflationary expectations getting out of control and causing longer-term interest to rise has not been a market issue up to this point in time.Inflationary expectations have been a problem for another reason: forecasting the movement of interest rates.At the end of last year most forecasters, myself included, were basing their projections of future interest rates on a rise in inflationary expectations. Inflation had been very low and moderate for some time, but with the expectations that economic growth would pick up, it was believed that inflationary expectations would also rise and this would cause longer-term interest rates to rise.The year 2014 started out with the yield on the 10-year Treasury bond around 3.00 percent. Inflationary expectations at that time for the ten-year period was 2.3 percent…and expected to rise.Guess what happened? The United States had a “bad” weather streak in the first and second quarters of the year and economic growth came in quite weak. From February through April, inflationary expectations dropped because of the weak economy and fell into the 2.15 percent to 2.20 percent range. And, the yield on the 10-year bond fell…against predictions.As the economy seemed to pick up in the third quarter, inflationary expectations picked up once again and in July and August they rose into the 2.25 percent to 2.30 range.But, concern over the weak economy rose again and inflationary expectations dropped.The observation of the weak economy and the reduction in the Fed’s outlook for inflation got translated into the financial markets and inflationary expectations declined to below 2.10 percent.This was a real shock! There were very few analysts, if any, that thought that inflationary expectations might decline this year!As a consequence the 10-year Treasury security closed to yield 2.53 percent on Tuesday, September 23…down about 50 basis points from the end of the year 2013.Right now, I think this shows two things. First, inflationary expectations play a very important role in the determination of longer-term interest rates. And, right now, inflationary expectations are very volatile. It can be argued that we are in a very unusual time and hardly anyone really knows what is going to happen.Some believe that we are in a cyclical recovery from the Great Recession and yet economic growth remains very tepid.Others believe that we are in a period of secular stagnation and this must work itself out over a longer period of time. But, we know little about secular stagnation’s and what works or doesn’t work during such times.Also, we understand very little about the problems of the banking system in such an environment and what is going to happen to all the excess reserves that now reside within the banks.The second thing is that we are living in a period of great uncertainty. The volatility in the market place is good for traders but not so good for investors that want to hold onto bonds for the longer-term. These investors are going to have a difficult time over the next couple of years figuring out exactly where yields on longer-term bonds are going to go. Thus, if they need to invest in bonds they must go ahead on invest and hold on to their investments and live through all the volatility that the bond markets will be experiencing.If a longer-term investor cannot live with such volatility then bonds are probably not the place they should be.About John Mason John has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.