The Best Illustration of Fed's Inflation Relations With Markets

If you want one chart that sums up what happened Wednesday -- from the hotter-than-expected inflation data released in the morning to the surprisingly cautious tone Federal Reserve Chair Janet Yellen struck in the afternoon -- look no further than the U.S. Yield curve.

The spread between 10-year U.S. Treasury yields and five-year yields fell close to the narrowest level since 2008 after consumer price index data released in the morning by the Labor Department in Washington showed faster inflation than most forecasters expected.

In other words, the inflation risk premium -- the amount of compensation investors require to hold a 10-year note instead of a five-year note to protect against the risk that inflation will eat into the return of the bond over the longer period -- actually fell, even though inflation is accelerating.

The reason: investors expected the data may prompt the Fed to raise rates faster, which could, in turn, slow the economy and ultimately weigh further on already-low longer-term interest rates, says Vince Foster, a portfolio manager at Southern Bancorp.

Instead, Fed policy makers signaled they would effectively do the exact opposite when they announced in the afternoon that they expected to raise the federal funds rate fewer times this year than they did previously -- and even fewer times than most thought they would admit.

Inflation Downgrade

Even more surprising was their forecast for where inflation would be by the end of 2017, which they downgraded despite the recent pickup in price pressures. The median of the 17 Fed officials who sit on the Federal Open Market Committee saw inflation -- defined as the year-over-year change in the price index of personal consumption expenditures excluding food and energy -- ending next year at 1.8 percent. That’s only a tenth of a percent higher than where it was in January of this year.

That, and Yellen’s comments in an ensuing press conference that recent inflation readings were being boosted by “transitory factors” that could reverse, caused the flattening of the yield curve to not only subside, but turn into the biggest one-day steepening in 17 months.

“The curve calibrates the inflation risk premium against the stance of monetary policy, or acts as a governor: flattening when it sees the Fed as hawkish and steepening when the Fed is dovish,” Foster says.

Yellen and her colleagues need to find a sustainable way to boost the inflation risk premium in markets if they are going to continue raising rates. If they can’t do that, but decide to move forward with tightening anyway, they run the risk of bringing about the ultimate nightmare scenario: an inverted yield curve with interest rates too close to zero.

To contact the reporter on this story: Matthew Boesler in New York at mboesler1@bloomberg.net. To contact the editors responsible for this story: Carlos Torres at ctorres2@bloomberg.net, Brendan Murray, Alister Bull

By: Matthew Boesler

©2016 Bloomberg News