By Caroline Salas and Scott Lanman
May 23 (Bloomberg) -- The cue for the Federal Reserve to start withdrawing its record monetary stimulus may be a measure of its own credibility: inflation expectations.
Expectations for annual consumer-price gains have jumped by 43 percent to 2.10 percentage points since the central bank began its second round of asset purchases in November, as measured by the breakeven rate for five-year Treasury Inflation Protected Securities. The measure is close to levels before the recession -- when the central bank?s benchmark interest rate was 5.25 percent, compared with about zero today.
?It?s highly likely that some movement in inflation expectations will be the first signal that they need to take action,? said J. Alfred Broaddus, 71, former president of the Federal Reserve Bank of Richmond, whose career dates back to the inflation surge of the 1970s. ?The Fed is right to be watching this very, very closely.?
Central bankers are starting to debate how and when to tighten policy after buying $2.3 trillion of assets to bring the economy out of the recession. William C. Dudley, president of the Federal Reserve Bank of New York, says the Fed still has a ?considerable way to go? to reduce unemployment from 9 percent, while other policy makers, including the Philadelphia Fed?s Charles Plosser and Richard Fisher of Dallas, say waiting too long to tighten risks igniting inflation.
?This is one of those really critical turning points in monetary policy where it?s pretty clear the next move is toward tightness, and the whole question is timing,? Broaddus said.
Buying TIPS
Sean Simko, who oversees $8 billion in fixed-income assets at SEI Investments Co. in Oaks, Pennsylvania, said he?s buying Treasury Inflation Protected Securities because higher commodity prices are stoking inflation. Five-year breakeven rates reached 2.47 percentage points on April 29, their highest level in almost three years.
?The TIPS market represents a fair assessment of inflationary pressures,? Simko said. Breakeven rates are the yield difference between TIPS and comparable maturity Treasuries and are a measure of the outlook for consumer prices over the life of the securities.
Dudley, in a May 19 speech in New Paltz, New York, said the central bank is falling short of its goals because unemployment is too high and inflation is likely to ease. While measures of the public?s view of inflation ?remain stable,? Dudley said, ?it is critical that we ensure that inflation expectations do not become unmoored.?
Bernanke Press Conference
Chairman Ben S. Bernanke, in his first press conference April 27, indicated that the central bank won?t remove stimulus immediately after ending $600 billion in bond purchases in June. At the same time, he highlighted inflation expectations as a reason the Fed might tighten credit.
?If inflation persists or if inflation expectations begin to move, then there?s no substitute for action,? Bernanke, 57, said following a meeting of the Federal Open Market Committee. ?We would have to respond.?
Policy makers watch expectations because they can fuel actual inflation. Businesses may raise prices in anticipation of higher production costs, while consumers can demand higher wages to keep up with the price of goods. Unless restrained by central banks, the two processes together can accelerate inflation.
?It is much harder to keep inflation in check if people begin to raise their expectations of inflation,? Dudley said in his May 19 speech.
Inflation is a ?mindset,? and consumers build their expectations into their behavior, said Ward McCarthy, chief financial economist at Jefferies & Co. in New York. While breakeven rates are within the Fed?s target range, ?they?re right on the frontier. There?s not a lot of breathing room.?
?Important Force?
Inflation expectations, especially long-run projections, ?are an important force in inflation dynamics,? according to a 2008 research paper from the Federal Reserve Bank of Kansas City by Todd E. Clark, who?s now a vice president at the Cleveland Fed, and Troy Davig, now a senior economist at Barclays Capital in New York. ?Even small movements in long-run expectations can represent a persistent source of pressure on inflation,? they wrote.
The authors cite as evidence several studies showing a link. The Fed?s own computer model of the U.S. economy uses long-run expectations, as measured by surveys of professional economists, as a ?key determinant of inflation behavior,? Clark and Davig said.
The central bank aims for an inflation rate of about 1.7 percent to 2 percent, based on last month?s long-run economic projections of Fed governors and regional presidents.
Jeans, Hamburgers
Prices in March rose 1.8 percent from a year earlier, accelerating for a fourth straight month to the fastest pace since May 2010, as companies from San Francisco-based jeans supplier Levi Strauss & Co. to Oak Brook, Illinois-based fast- food chain McDonald?s Corp. announced price increases to make up for rising prices of cotton, wheat and other raw materials.
Excluding food and fuel, prices rose 0.9 percent in March from a year earlier, near a five-decade low of 0.7 percent. Fed officials prefer the so-called ?core? measure because food and fuel costs are more volatile.
Inflation, including all items, has averaged 2.1 percent a year over the past 10 years, and the same rate over the prior decade. It was 4.8 percent during the 1980s and 6.7 percent in the 70s, based on the Commerce Department?s personal consumption expenditures price index.
St. Louis Fed President James Bullard said May 18 that central bankers are ?determined? to avoid a repeat of the 1970s inflation. Paul Volcker, who took over as chairman in 1979, kept the federal funds rate on overnight loans among banks above 8 percent for more than five years, pushing it as high as 20 percent.
Forecasters Erred
During that decade, ?forecasters consistently underpredicted the future level of inflation, seeing considerably more disinflation from a particular policy stance than in fact occurred,? former Fed Vice Chairman Donald Kohn said in a 2007 speech. Fed staff economists and bond investors both made such mistakes, Kohn said.
?I lived through that whole thing, and it was awful,? said Broaddus, who joined the Richmond Fed in 1970 and ran it from 1993 to 2004. Even though there hasn?t been an incident of similar magnitude since then, policy makers ?know that can happen,? he said. It?s ?always out there as the lesson of what can happen if the Fed begins to lose focus on its main job of focusing on price stability.?
Now Fed officials often speak of the credibility they regained from Volcker?s inflation victory and how careful they must be not to let it slip away.
Business Cycle
?This is the point in the business cycle when the risk of losing a bit of credibility and risk of losing ground on inflation is highest,? Jeffrey Lacker, the current president of the Richmond Fed, told reporters May 10.
The market-based measure of inflation five to 10 years out ?is a proxy on their credibility completely,? Davig said. ?Any kind of financial market movement that would indicate the market?s lack of belief in the Fed?s ability to execute a smooth exit strategy -- the Fed?s completely fearful of that.?
The five-year breakeven measure has dropped 0.37 percentage points since the end of April, even as the total Consumer Price Index rose 3.2 percent last month from a year earlier. A measure of inflation five to 10 years out has fluctuated this year in a range of 2.77 percent to 3.14 percent.
Five-year breakevens traded in a range of 2.08 percent to 2.91 percent from 2004 through July 2007, just before concerns over the value of housing debt sent banks? borrowing costs surging. The five-to-10-year index traded from 2.34 percent to 3.31 percent.
?Timely Manner?
A minority of Fed officials are concerned that the Fed?s record balance sheet risks igniting dangerous price increases. A failure to exit ?in a timely manner could have serious consequences for inflation and economic stability in the future,? Philadelphia?s Plosser said in a March speech.
?Should it prove necessary to counter inflationary pressures, I will be among the first to advocate the unwinding of some of the stimulus we have provided,? Fisher said May 4.
Any interest-rate increase may still be far off, as the threat of rising expectations receded this month, giving the Fed breathing room. ?You?ve got global uncertainties, some of which are abating, commodity prices moving off their peaks and oil prices drifting down, so I think that?s helpful,? Bullard said in an interview May 18.
?Transitory? Inflation
While the FOMC reiterated its view in the April 27 statement that the boost to inflation from higher commodity prices will be ?transitory,? Fed officials must be careful not to assume both food- and energy-price increases will dissipate and have little persistent effects on inflation, Davig said in an interview.
?Food prices have a tendency, when they go up, to be more persistent, and we do see that spillover from higher food prices into longer-term measures of inflation,? he said.
The attention the Fed pays to inflation expectations means investors, whether they agree with the central bank or not on the measures? importance, must pay attention themselves.
?The Fed absolutely does believe that inflation expectations matter,? said Steve Lear, who helps oversee $130 billion as deputy chief investment officer at J.P. Morgan Asset Management in New York. ?Needless to say, we care because the Fed cares.?
--With assistance from Craig Torres in Washington. Editors: Christopher Wellisz, Carlos Torres
To contact the reporters on this story: Caroline Salas in New York at csalas1@bloomberg.net; Scott Lanman in Washington at slanman@bloomberg.net
To contact the editor responsible for this story: Christopher Wellisz at cwellisz@bloomberg.net
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