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Tuesday, March 11, 2008

Inflation, Inflation, Inflation

Inflation, we have been talking about, the market has been talking about it, but has the Fed? In short the answer is yes, but it appears the market may not think so. For the first time since its introduction in 1997, the 5-year TIP traded at a negative yield, implying a significant lack of confidence in the Fed's ability to fight inflation. The market is essentially betting that the Fed has lost sight of inflation and is solely targeting growth. We do not agree with the market's assessment. First off, lets rehash an early blog post titled 'Fed Cuts & Inflation' :

"So long as the Fed considers downside risk to growth exists we can expect that rate cuts will remain on the table as long as Core PCE remains below the 2.7% to 3.0% range, or growth conditions do not deteriorate more significantly.

To be more specific, so long as demand continues to be a drag on growth and inflation remains within a 'comfortable' level, the Fed will cut rates. However, if inflation exceeds the Fed's comfort level (as defined above), then we would likely see a quick reversal of policy, or at least the end to rate cuts. Core PCE for January finished 2.18%y/y vs 2.23%y/y the month prior. The Fed has not forgotten their dual mandate. The Fed realizes inflation is trending up, and it is clear that in addition to rate cuts they are looking for alternative methods to alleviate the credit crisis.

With this in mind, to us today's Fed announcement implies a smaller rate cut at their official meeting on March 18th. We were originally calling for a rate cut of 75bp, but this move, pending how the market reacts over the coming days, changes our forecast to 50bp (with 25bp being a possibility). Of course the relationship between further easing and inflation wasn't the only topic on the Fed's mind in making this decision, but it was probably a factor. The bottom line is the Fed is well aware of inflation and will act accordingly. Markets can only trade irrationally for a finite period of time.

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