Is Monetary
Policy Too Easy?
The Fed has been battling deflation since the financial
crisis began in 2008. Negative
demographic trends and an over leveraged economy have led to sluggish growth in
spite of unprecedented easing by the Fed.
The Fed Funds rate has been near zero for several years and the Fed’s
balance sheet has ballooned as the Fed introduced us to Quantitative Easing
(QE). After the first round of QE the
Fed moved on to QE2, QE3, and QE “infinity.”
The latest round of QE appears to be drawing to an end as the Fed continues
to taper its purchases of UST and Mortgage bonds. Research has shown QE has diminishing returns
and encourages the movement of funds into riskier assets. It also slows down or drags out the
deleveraging process. We have seen
improvement in a very weak labor market, but the economy has been very
sluggish.
Inflationary
Pressures May Be Building
Inflationary expectations have been well anchored which
has allowed the Fed to continue its monetary easing without upsetting the Fixed
Income markets. The bond vigilantes have
been silent and are not expressing concern.
However, we are seeing early warning signs that inflation is starting to
pick up. The chart below shows the Core
rate of the CPI since January 2008. The
blue line is the year over year rate of inflation and is less sensitive to
monthly changes in the index. It is
increasing at a rate of 1.9% annually which is roughly in line with the Fed’s
target. The red line is the annualized
rate of the last 3 months of the CPI. It
is more sensitive to recent monthly changes in the index. This shows a different story, as it is growing at an annualized rate of 2.8%.
This is the
highest this measure has been since early 2008.
We view this as a red flag that inflation may be picking up.
We will be watching this measure closely for further signs that inflationary
pressures are building.
The Taylor Rule
The chart below shows the projected Fed Funds rate using
the Taylor Rule Model. This model uses
the Core PCE deflator for the measure of inflation. The model currently says the Funds rate
should be 1.84%.
The Model below uses the Core CPI to measure
inflation. Using this measure the model
says the Funds rate should be 2.7%.
Conclusion
The Taylor Rule model shows the Fed Funds rate is too low
for the strength of the economy. The
recent strength in the annualized inflation rate using the last 3 months of
Core CPI shows inflation may be picking up.
This is making us more cautious to the rates markets and we will be
watching closely for further signs of an inflationary buildup.
