EC Discounting Policy Errors

The actual data is elevated. Consumer prices are rising at an annualized pace a little north of 6%. April's PCE deflator, which the Fed targets at 2%, will be released on May 28. It rose at an annualized rate of more than 4% in Q1. Assuming that the median forecast in Bloomberg's survey is correct and the PCE deflator rose by 0.6% last month, which would be the highest monthly print since 2008, the annualized rate closer to 5%.  

Numerous anecdotal reports suggest that the anticipation of higher prices, like building materials, encourages a postponement of some projects. That points to the possibility that actual and anticipated inflation is reducing current economic activity, and maybe part of the disappointment with last week's April housing starts (-9.5% vs. median expectations for a 2.0% decline after a revised 19.8% gain in March).  

I am not convinced that we know enough about inflation to be so adamant about it. The old relationships (e.g., money supply growth, unemployment, significant debtor issues) have weakened, were never so strong, to begin with, or have completely broken down. Many economists and central bankers continue to argue that price pressures will increase only when the labor market slack is absorbed.Yet, with low levels of unemployment in 2019, inflation was still undershooting targets.  

The noted Fed watcher and Queens College President El-Erian expressed the thinking of many when he argued that that the Fed may be making a policy mistake. He concludes that its stance cannot be explained by the normal drivers of monetary policy. This is fair as far as it goes, but it does not do justice to the extent of doubts about recent Fed moves. There are three other areas of concern.  

First, the Fed is allowing the pressure to build up in the money markets, driving some rates, like the general collateral repo rate below zero. In the past, the Fed has moved (increase the interest on reserves when the Fed funds rate is within five basis points of the lower bound. It is six now but did dip to five basis points at the end of April. The use of its reverse repo facility reached a new pandemic-era high of $294 bln last week. Pressure is likely to continue for at least the next couple of months as Treasury Department reduces its cash position ahead of the end of the debt ceiling waiver.    

Second, the System Open Market Account manager suggested in early April that the Fed's intent to keep its purchases in line with Treasury issuance would necessitate a technical adjustment in the coming months. There does not appear to be a compelling reason this was not done ahead of last week's 20-year bond auction. The result was lukewarm reception that saw higher yields and a lower bid cover.  It left dealers with 23.8% of the supply, up from 21.1% at the last auction.  

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Read more by Marc on his site Marc to Market.

Disclaimer: Opinions expressed are solely of the author’s, based on current ...

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