Is Monetary Policy Too Easy?

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.