Fed Changes Its Tune

The Federal Reserve has a problem.

The yield curve is inverted. Meaning long-term rates are lower than short-term rates.

The Fed funds rate (set by the Fed) is essentially at the same level as the 10-year Treasury bond. The 2-year, 3-year, and 5-year Treasury bond rate is well below this around 2.3% (see neon green line). The shape is much different than 6 months (red line) or even a year ago (blue line). Looking back, the 10-year yield was north of 3% and all of these interst rates were higher. The yield curve was steeper.

What does it mean?

The bond market is telling the Federal Reserve that policy is too tight, betting that short-term interest rates have risen too far and too fast.

Admitting mistakes is tough, and the Fed probably did not need to raise interest rates in September and December of last year. The committee that sets rates needs intellectual cover on how to change the shape of the curve and lower interest rates.

Enter inflation targeting.

In 2012, the Fed set an inflation target of 2%. It cannot seem to get there.

The target is measured by the Core Personal Consumption Expenditures (PCE) index. Since then, inflation averaged 1.6%, right in line with its latest reading. Since the inception of this measure, it averaged 1.7%.

Some may be thinking, “I wish the stuff I bought only went up about 1% to 2% a year.” The following chart shows how various consumer goods and services have changed in price over the last 20 years. Many are much higher than a 2% per year increase.

The Fed missing its 2% target by a few tenths of a percent does not sound like much, especially faced with the 200% increase in healthcare costs.

However, it is a big enough issue that they have been holding discussions and roundtables around the country the last few months. They need to figure out how to get inflation up!

This culminates in the Conference on Monetary Policy, scheduled for June 4th and 5th. One possible way to change policy is using an average of inflation over time, allowing it to rise above 2% in good times, perhaps as high as 2.5%. Since it has fallen below 1.5% in economic slowdowns and recessions, this would allow the average to be 2% over a cycle. This could be the biggest change in Fed policy in eight years.

The policy being discussed is averaging inflation over a period time. This gives them reason to keep monetary policy easier (and even lower interest rates), which is what the bond market is pricing in by early 2020.

With tariffs taking center stage again, the Fed is watching for signs of slowing growth and inflation missing its target. If data disappoints, it gives them enough reason to call for a ‘maintenance interest rate cut.’

While just six months ago, the bond market was thinking about 2 to 3 hikes in 2019. Now a rate cut is on the table.

The yield curve controls Fed policy. We are seeing that in action today.

Questions about this blog? Contact Michael McKeown, CFA, CPA – Chief Investment Officer.

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