Tags: FOMC | credibility | inflation | denia

FOMC Is in Denial

Friday, 26 Oct 2012 01:50 PM Current | Bio | Archive

The Federal Open Market Committee (FOMC) has crossed the Rubicon.

Our analysis suggests that the FOMC, which met this week, is deliberately ignoring data on both growth and inflation. At best, the FOMC’s intention might have been to not rock the markets two weeks before the election. At worst, the FOMC has given up on market transparency in an effort to actively manage the yield curve (short-term to long-term interest rates).

• On growth: Economic data, including the unemployment report, have clearly come in better than expected since the last FOMC meeting. FOMC practice dictates that progress in economic growth is acknowledged in the statement from the meeting. Instead, the assessment of the economic environment is verbatim. Had the FOMC given credit to the improved reality, the market might have priced in earlier tightening. The FOMC chose to ignore reality, possibly afraid of an unwanted reaction in the bond market.

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• On inflation: The FOMC correctly points out that inflation has recently picked up “somewhat.” However, it might be misleading to blame the increase on higher energy prices, and then claim that “longer-term inflation expectations have remained stable.” Not so, suggests an important inflation indicator monitored by the Fed and economists alike: five-year forward, five-year inflation expectations broke out when the Fed announced QE3, its third round of quantitative easing, where the emphasis shifted from a focus on inflation to a focus on employment. This gauge of inflation measures the market’s expectation of annualized inflation over a five-year period starting five years out, ignoring the near term, as it might be influenced by short-term factors.


The chart shows that we have broken out of a 2 standard deviation band and that the breakout occurred at the time of the QE3 announcement. In our assessment, the market disagrees with the FOMC’s assertion that longer-term inflation expectations have remained stable. At best, the FOMC ignores this development because they also look at different metrics (keep in mind that the Fed’s QE programs manipulate the very rates we are trying to gauge here) or has a different notion of what it considers longer-term stable inflation expectations. At worst, however, the FOMC is afraid of admitting to the market that QE3 is perceived as inflationary.

In our assessment, inflation expectations have clearly become elevated. Ignoring reality by ignoring growth and inflation might not be helpful to the long-term credibility of the Fed. Fed credibility is important, as monetary policy becomes much more expensive when words alone don’t move markets anymore.

We manage the Merk Hard Currency Fund, the Merk Asian Currency Fund, the Merk Absolute Return Currency Fund, as well as the Merk Currency Enhanced U.S. Equity Fund.

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies.

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The Federal Open Market Committee (FOMC) has crossed the Rubicon. Our analysis suggests that the FOMC, which met this week, is deliberately ignoring data on both growth and inflation.
Friday, 26 Oct 2012 01:50 PM
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