Post FOMC charts and comments

Going into the FOMC meeting, the market was priced to a 30% chance that the Fed would begin "liftoff." In the aftermath of the Fed's announcement that it would postpone liftoff, short-term interest rates adjusted downwards by about 7-8 bps, which is roughly one-third of a 25 bps "tightening." Translation: the market moved rationally, pricing out what had previously been priced in. Implied volatility and the equity markets jerked around, however, but ended relatively unchanged. So on balance the FOMC announcement was a non-event. It resulted in a very modest reduction in interest rates, but did not increase or decrease uncertainty, leaving the fundamentals reasonably healthy: 2-year swap spreads inched higher to 12.7 bps, but remain very low; gold inched higher but remains in a multi-year downtrend; the dollar inched lower but remains relatively flat year-to-date, and close to its long-term average valuation relative to other currencies; and credit spreads were relatively unchanged while remaining somewhat elevated.

With implied equity volatility relatively unchanged but yields lower, the Vix/10-yr ratio inched higher, but remains significantly below its peak of a few weeks ago. The market is still nervous and still concerned that the U.S. economy is going to prove sluggish, but the outlook is no longer as dire as everyone thought. Equity prices have predictably responded to a reduction in fear and uncertainty by increasing.

Recent changes to gold and 5-yr TIPS prices have been minor, when seen from an historical perspective such as the chart above affords. Both remain in a downtrend, a sign that the demand fro safe assets is declining and that therefore the market is becoming less concerned about drastic outcomes. Fear and uncertainty are gradually being displaced by a slow return of confidence.

The first of the charts above compares the nominal yield on 5-yr Treasuries to the real yield on 5-yr TIPS, and the difference between the two which is the market's expectation for inflation over the next 5 years (1.3%). Not surprisingly, near-term inflation expectations have declined over the past year. As the second chart shows, lower inflation expectations are almost entirely the result of lower energy prices. This also is rational, and does not reflect negatively or positively on the Fed's policy stance.

 The chart above shows inflation expectations for years 5 through 10—currently about 1.9%.

The chart above shows inflation expectations for the entirety of the next 10 years—currently about 1.6%. In other words, the market sees inflation being relatively low for years 1-5 (1.3%), but then picking up to 1.9% for years 5-10, and averaging 1.6% for years 1-10. That's not significantly less than the annualized increase in the CPI over the previous 10 years of 1.95%. As John Cochrane notes,

The outcomes we desire from monetary policy are about as good as one could hope. Inflation is low and steady. Interest rates are lower than Americans have seen in generations. Unemployment, at 5.1%, has recovered to near normal. And banks and businesses sitting on huge piles of cash don’t go bust, a boon to financial stability.

Although far from ideal, things could be a lot worse. There is no evidence to date that the Fed has made any serious mistakes. For newer readers, I note once again that—contrary to popular belief—the Fed has not been printing money, and instead has been merely accommodating a very strong demand for money by swapping bank reserves for notes and bonds.

I continue to worry that when the time comes to raise rates, the Fed will move too slowly, and this will result in an unpleasant increase in inflation and eventually much higher interest rates. But for now this is only something to keep a sharp eye out for. I don't yet see hard evidence of a decline in the demand for money which would precipitate a meaningful rise in inflation, but I have not let down my guard on this. That's the important point: it's all about the demand for money. If the demand for money falls and the Fed fails to counteract that by reducing bank reserves and raising the rate it pays on excess reserves, then inflation and inflation expectations should rise.