Summary – Fed Avoids Being “Very Wreckless”

Fed Chairman Bernanke’s recent press conference provided a wealth of insight into the FOMC but perhaps

most telling was his statement that pursuing higher inflation in order to tame unemployment would be “very

wreckless”. This was in response to much confusion around the difference between “Ben the academic”

who argued for massive money printing in the case of Japan in the 1990s and “Ben the practitioner” who is

in action today. The Chairman’s argument holds as today’s positive inflation expectations argue against

priming the pump too aggressively.

In short, it will take more than a slowing economy to drive a successful argument for QE3. There will also

need to be significantly lower inflation expectations with a real risk to possible deflation before Bernanke will

go back to the well.

What’s Important…

Today’s inflationary expectations remain a warning sign. In 2010, the market’s expectations for inflation

hovered around 1.25 percent and had been heading down from the 2 percent level. After QE2, lower yields

and expanding activity drove the inflation outlook upward to a high of nearly 2.75 percent. Today, this

measure (as proxied by the TIPs market) has held steady at around 2 percent over recent months. The Fed

wants nothing to do with outsized inflationary activity and Bernanke will do all in his power to avoid this

risk.

Bernanke makes clear: The Fed cannot offset the coming “fiscal cliff”. The coming resets of tax and spending

activity at the beginning of 2013 are much too large for the Fed to counteract according to an answer the

Chairman gave in his April press conference.

The Fed is targeting 2 percent inflation – but that may be a maximum rather than a target. Though stating 2

percent as its target, it is clear that the Fed is unhappy with inflation anywhere above that level. Inflation is

much more on the minds of the Fed than employment.

Six of the seventeen FOMC members forecast higher rates prior to 2014. But, make no mistake about it,

Bernanke is the decision-maker here.

“Exceptionally low” rates equals today’s levels. Another item that was clarified in the April press conference is

the FOMC’s use of the phrase “exceptionally low”. In response to a question, Bernanke made clear that any

rate increase would be a deviation from “exceptionally low” levels, which likely means this nomenclature

will be dropped from the FOMC statement prior to any rate increase. The Fed may be trying to

communicate an exit strategy with the dropping of this language being the first step. More to come…but

much later.

Quick Hits: The Fed May 1, 2012

What to Look for…

The Fed is currently reacting to signs of strength in the broad economy that came about in the first quarter.

Unfortunately, there have more recently been significant signs of a possible slow-down in the second.

Should a slow-down appear, along with decreased inflationary pressures, the Fed could reverse course

quickly and begin talking QE once again. However, lower inflationary expectations are the primary key to

any further stimulus. Otherwise, the Fed will be content with below-potential GDP growth and higher than

usual unemployment for “an extended period”.

A Picture is Worth…

Source: Federal Reserve

The above chart plots FOMC member forecasts of the appropriate timing of a Fed rate increase. While the publicized statement points to “late 2014” as the target, you can see a wide disparity among the people at the table. My first takeaway is the fact six members believe rates will need to be increased in 2013, including three that believe a rate increase should occur this year! My second takeaway is that 2014 is likely far enough into the future that an assumption of mean reversion may be the driving force. Instead, we could find these measures actually moving out into the future if we don’t see significant economic progress later in the year. Written by:

Joe Morgan Chief Investment Officer SVB Asset Management @SVBJoeMorgan jmorgan@svb.com

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Forecasts of Appropriate Timing of Policy Firming