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Traders Diverging From Economists Puts Fed in a Bind

Traders Diverging From Economists Puts Fed in a Bind

(Bloomberg Opinion) -- The market wants the Federal Reserve to reduce interest rates. Economists, on the always present other hand, are insistent that policy makers should not cut and stand pat. This divergence in opinion between the market and economists that was initially an interesting curiosity has metastasized into a headache for the Fed.

Why is this happening? Economists see strong growth, citing the better-than-expected 3.2% gain in first-quarter gross domestic product, the impressive 236,000 increase in April payrolls and the rebound in many economic statistics since the fourth quarter. Some economists are even mockingly asking, “where’s the recession?” They are not wrong.

So, what does the market see? No inflation. Fed Chair Jerome Powell said on May 1 after the last monetary policy meeting that the current low rates of inflation were “transitory” and that “many little things” are the cause. He then cited, of all things, portfolio management and investment advisory services! So, the relentless pressure on fees applied by passive exchange-traded funds and lousy hedge fund manager performance causing them to cut their 2%/20% fee structure is holding down inflation for everyday Americans? Wow! Thankfully this was thoroughly debunked soon after it was said.

Powell neglected to mention a big problem on the other side of the ledger. Rent and Owner’s Equivalent Rent inflation is booming and could be peaking. This chart shows three-month annualized CPI Owner’s Equivalent Rent and Rent of Primary residences inflation for April (PCE is only current through March). They are at 13-year highs. These measures collectively make up a whopping 30% of Core CPI! Housing inflation is approaching the peak seen during the real estate in 2006. Short of another mega housing bubble to fuel higher prices, it looks more likely to decline and drag down core inflation.

Traders Diverging From Economists Puts Fed in a Bind

Additionally, inflation expectations are falling. This is shocking given a massive tariff increase to 25% on $200 billion of Chinese goods, and threats of another $300 billion more.

Traders Diverging From Economists Puts Fed in a Bind

Could it be that the Trump administration raises tariffs on $500 billion of goods and inflation does not move? These and other markets say it could be the case. This would leave the Fed speechless.

Finally, the measures might be all wrong -- again. In a speech at the University of Pennsylvania's Wharton School last month, former Fed Chairman Alan Greenspan made some interesting remarks:

“Because products are continuously changing, ….. when new products go on the market, they come in at relatively high prices. Henry Ford’s Model T came in at a very high price, and the price went down as technology improved. You didn’t start to pick up the price level until well into that declining phase.”

“So there is a bias in the statistic. You’re getting statistics which are not correct. … If you had a 2% inflation rate as currently measured, it’s the equivalent of zero for actually what consumers are buying.”

So, Greenspan is suggesting that the true inflation might be closer to zero!

Is this why the bond market’s term premium is negative? The term premium is the extra compensation demanded by investors for bearing the interest-rate risk associated with longer-term securities. Federal Reserve Bank of New York economists Tobias Adrian, Richard Crump, and Emanuel Moench developed what is now the standard measure of the term premium.

Many economists, academics and even Fed officials frequently conclude that a negative term premium is an indication that interest rates are too low. They say that long-term rates are not properly compensating investors for a Fed targeting a 2% inflation rate. But this has been the case for almost five years. Instead of this market being mispriced for half-a-decade, could it be that the 93-year-old Greenspan is forward looking and the term premium is priced to a zero-inflation rate?

Traders Diverging From Economists Puts Fed in a Bind

The Fed believes that inflation will collapse in the next recession. So, they want to target a 2% inflation rate so that there is enough of a cushion to prevent deflation, which stresses the banking system. And yet, the market is sending an unambiguous signal that rates are restrictive and the Fed should ease monetary policy. But the market sees low inflation as the problem and not a perception of weak growth or an imminent recession.

With stocks near all-time highs, however, policy makers are afraid of what Federal Reserve Bank of Kansas City President Ester George said last week, which is that lower interest rates might fuel asset price bubbles, create financial imbalances and ultimately a recession.

The Fed is stuck. The market wants rates to be cut, the central bank is afraid of fostering bubbles.

Recessions happen because something “breaks” an otherwise healthy economy. The leading reason behind those breaks is a tight Fed. So, as the Fed tries to figure out what causes inflation, the clock is ticking. Do policy makers want to risk policy being too tight by defying market signals to cut? Or do they fear a cut means a financial bubble? 

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Jim Bianco is the President and founder of Bianco Research, a provider of data-driven insights into the global economy and financial markets. He may have a stake in the areas he writes about.

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