Lower Inflation Expectations Gives Fed More Leg Room

In the most recent meeting minutes of the Fed, it was revealed that the central bank was still open to more easing. But it has been two weeks since the event so I thought I’d revisit the issue. The Fed’s interest rate decision is fast approaching and I know a lot of you are wondering whether the central bank will engage in more easing or not.

There appears to be two sides to this argument. On the one hand, the market thinks that we will see more quantitative easing, as inflation expectations are falling. On the other hand, top U.S. bank officials are saying that the economy is doing just fine and doesn’t need more stimulus.

Inflation Expectations

Due to the fears that the euro zone’s problems will have a negative effect on U.S. growth, the market’s inflation expectations are falling. A report from Bloomberg showed that the difference between the yields of the 10-year Treasury bonds and the Treasury Inflation Protected Securities, or TIPS, has dropped to just 2.13% in May from 2.42% the month before.

Traders call this 2.13% number as the “breakeven inflation rate” and it represents the expectations for the average annual inflation for the next decade. This is a sharp contrast from two months ago, when inflation expectations were high enough that additional quantitative easing action from the Fed would’ve been construed as too aggressive and inflationary.

What this basically points to is that the Fed room to engage in more easing, and traders believe that the central bank will actually do it.

Bank Officials Disagree

St. Louis Federal Reserve Bank President James Bullard, for one, thinks that a “Grexit” may not cause too much damage to Europe and the U.S. IF handled properly.

He also thinks that the U.S. may surprise everyone and perform much better than the markets expect. In fact, he has so much conviction in his belief that he predicts an increase in interest as early as 2013 (and not 2014 as the FOMC had previously indicated)! Leave it to Bullard to look on the bright side of things, eh?

Meanwhile, Minneapolis Federal Reserve President Narayana Kocherlakota cites elevated inflation and employment levels as the main reasons why the Fed should start looking into exiting its ultra-loose monetary policy. According to Kocherlakota, inflation could hang around 2% this year and rise to 2.3% in 2013.

Furthermore, he believes that these serve as signals that the labor market may be closer to “maximum employment” than reports suggest. “As I’ve argued in the past, appropriate policy should be responsive to such signals,” declared Kocherlakota in a recent statement.

Learn to read between the lines, my friends. By saying “appropriate policy should be responsive,” he’s basically telling us that rates need to be increased!

As insightful as these statements are from Bullard and Kocherlakota, you have to keep in mind that these two are non-voting members of the Fed’s policy-setting board. In other words, they don’t make the decisions!

Overall, we have to acknowledge that although inflationary data shows that the outlook is frail, it’s not weak enough to push the FOMC to pull the QE trigger in the next interest rate announcement.

Unless things really take a turn for the worse, the Fed will likely keep its wait-and-see stance. So if you’re part of the dollar bear camp that’s been hoping for QE3, there’s a big chance you’ll be sorely disappointed.

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