Five-Year TIPS Say Fed Undershoots IT Target—By Half?

A Benjamin Cole post

If the Fed were your haberdasher, you would get arrested for indecency—half dressed, so to speak.

The Treasury Inflation Protected Securities market, or the “TIPS market,” is a market-based predictor of inflation. These are bonds sold by the U.S. Treasury that protect investors against inflation, as measured by the consumer price index (CPI).

Right now, institutional investors are buying five-year TIPS that offer a yield of 1.27% more than the yield on regular five-year Treasuries. Ergo, the market says the CPI will run at 1.27% in the next five years.

But the Fed claims its average inflation target (IT) is 2%, and that rate is based on inflation as measured the Personal Consumption Expenditures price index (the “PCE deflator”). However, that index generally runs around 30 to 40 basis points below the CPI.

So, what Wall Street is saying is that inflation in the next five years will be under 1% on the PCE deflator—in other words, an inflation rate will be less than half of the Fed’s IT of 2%.

Fed Credibility?

From somber central bankers to crackpots, we have often heard pompous pettifogging about the need for central banker resolve and credibility…and now that Wall Street says the Fed will miss its IT target by half, where are the sanctimonious sermonettes? When the Fed says it’s IT is 2%, but the market says inflation is at 1%, the market is saying the Fed has no credibility.

It May Get Worse

According to a recent report from the Council of Economic Advisers, over-estimating inflation and interest rates are a chronic predilection of professional U.S.-based economists:

Ben Cole Aug19-15

The short story is that economists say interest rates will soon be 2% higher —a sentiment expressed at any time by forecasters, and wrong for 20 years in a row.

Conclusion

With consensus-builder Fed Chairman Janet Yellen in charge, and an entire profession inexplicably yet chronically over-impressed with the potential for inflation and interest rates to rise, I think we can expect Japanification to continue in the United States.

Indeed, the Fed might undershoot its IT target by half, yet raise interest rates within the calendar year.

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