Special Report-CPI, Fed policy and asset bubbles
Tuesday, May 18th, 2010A debate is emerging in the financial markets over whether the EU debt crisis will force the Fed to delay its exit strategy and will a potential delay increase the risk that Fed policy contributes to inflation and the creation of asset bubbles? Monday, the Feds Lacker said that maintaining interest rates at too low level for too long increases the risk of creating asset bubbles. Recent statements by a number of Fed officials suggest that that Fed believes that the US recovery is gaining momentum. As the economy continues to improve inflation risk may be skewed to the upside. Lacker also says that the creation of close to 600k jobs since the beginning of the year shows that the employment outlook is strengthening. Lacker went on to say that the Fed must be careful to avoid waiting too long to raise rates. On May 7th, the Fed’s Plosser said that he doesn’t see deflation risk and that inflation risks are to the upside over the medium and long run. Plosser went on to say that that the Fed is not yet ready to raise rates but he warned that the US is not out of the woods in regard to inflation. The Fed’s Kocherlakota said that he is worried the Fed’s expanding balance sheet could trigger inflation.
Plosser and a number of Fed governors would like the Fed to consider implementation of its exit strategy and to begin to sell assets. Fed policy outlook is complicated because of continued elevated US unemployment, the potential fallout from the Greek debt crisis, the impact of EU austerity measures and the risk that US recovery stalls in the second half of the year as fiscal stimulus is withdrawn and the Fed moves closer to reducing monetary stimulus. The Feds April FOMC policy statement reaffirmed commitment to exceptionally low levels of federal funds rate for an extended period. Despite improvement in the US economy the majority of Fed board members believe the Fed has great latitude in regard to monetary policy because continued slack in the US economy limits the near-term risk of inflation. Economists Wesbury and Stein write in today’s Forbes on line that they expect the Fed to remain on hold trough year end and inflation will rise.
On Wednesday, May 19th April CPI will be released. April CPI is expected unchanged at 0.1%m/m and 2.4%y/y with core annual inflation rate at 1%. Tuesday April PPI was released. April headline PPI declined by more than expected with core inflation up slightly above  expectation rising by 0.2%. Tomorrow’s CPI report will likely confirm that US inflationary pressures remain subdued. The US annual inflation data contrasts with today’s release of EU April annual inflation which rose to 1.5% compared to 0.6% year ago and UK April inflation which surged to 3.7%. The ECB and BOE believe that the current rise in inflation pressures will be temporary and primarily reflect rising energy prices. The sovereign debt crisis in Europe has forced the ECB and BOE to delay exit plans and normalization of rate policy. Rising inflation in Europe may foreshadow what lies ahead for the US if the Fed delays its exit strategy.
Recent price action in global equity markets and commodities save for the record rise in the price of gold suggests that the risk of current accommodative Fed policy creating an asset bubble has greatly diminished in the last few months. Crude oil prices traded to a new low for the year in Monday’s trade approaching $70 a barrel. China’s economy appears to be slowing. The Shanghai index declined by 5.1% Monday to its lowest level in over a year. The EU debt crisis and anticipated austerity measures may curb EU growth and hurt the US and global recovery. The price of copper traded at its lowest level since February of 2009 pressured by concern that the global economic recovery has slowed and in reaction to the strengthening of the USD. The EUR traded at a 14 month low versus the USD Monday. Strengthening of the USD tightens monetary conditions and is deflationary. These factors suggest that a debate about the creation of asset bubbles is unwarranted at this time and rumor that the Fed may be considering an earlier exit strategy is unwarranted.
The FOMC minutes for the April 28th policy meeting will be released on Wednesday, May 19th. The minutes are expected to confirm that the Fed will maintain low yields. Investors will be looking to see whether dissent on the Fed policy board remains limited to Hoenig. Hoenig wants the language of the Fed policy statement changed because he feels the current language limits the Fed’s flexibility to begin raising rates. Hoenig has dissented in the last three FOMC policy meetings. Investors will also be looking to see if more the Fed policy members seek the start of asset sales by the Fed.
Tuesday the Reserve Bank of Australia (RBA) released its policy minutes for May 4th meeting. The RBA suggests that the central bank is considering a pause in its rate hike cycle. Part of the reason for the pause is the recognition that he EU crisis has dampened the inflationary effects of the recent rise in resource prices. We suspect that the EU crisis may encourage the Fed to delay the start of its exit strategy as well. Additionally speaking over the weekend Chinese Premier Wen Jiabao said that there is a need to curb surging house prices in China but that the government must strike the right balance to support economic growth. According to Wen the Chinese economy continues to improve but domestic and external conditions remained extremely complex. Wen’s comments suggest that China may pause in its tightening cycle. The Chinese authorities and G-7 central banks are expected take a wait-and-see approach towards monetary policy tightening due to uncertainty about the potential contagion risk from the EU debt crisis and recent signs of slowing Chinese economy. The risk of Fed policy creating an asset bubble seems remote in light of the threat global sovereign debt contagion presents for the US economy and continued low US inflation. The Fed’s Pianalto says that he sees disinflation as the near term trend and inflation expectations are well anchored.
Written by Easy-Forex
