(Bloomberg News) The cue for the Federal Reserve to start withdrawing its record monetary stimulus may be a measure of its own credibility: inflation expectations.
Expectations for annual consumer-price gains have jumped by 43 percent to 2.10 percentage points since the central bank began its second round of asset purchases in November, as measured by the breakeven rate for five-year Treasury Inflation Protected Securities. The measure is close to levels before the recession -- when the central bank's benchmark interest rate was 5.25 percent, compared with about zero today.
"It's highly likely that some movement in inflation expectations will be the first signal that they need to take action," said J. Alfred Broaddus, 71, former president of the Federal Reserve Bank of Richmond, whose career dates back to the inflation surge of the 1970s. "The Fed is right to be watching this very, very closely."
Central bankers are starting to debate how and when to tighten policy after buying $2.3 trillion of assets to bring the economy out of the recession. William C. Dudley, president of the Federal Reserve Bank of New York, says the Fed still has a "considerable way to go" to reduce unemployment from 9 percent, while other policy makers, including the Philadelphia Fed's Charles Plosser and Richard Fisher of Dallas, say waiting too long to tighten risks igniting inflation.
"This is one of those really critical turning points in monetary policy where it's pretty clear the next move is toward tightness, and the whole question is timing," Broaddus said.
Buying TIPS
Sean Simko, who oversees $8 billion in fixed-income assets at SEI Investments Co. in Oaks, Pennsylvania, said he's buying Treasury Inflation Protected Securities because higher commodity prices are stoking inflation. Five-year breakeven rates reached 2.47 percentage points on April 29, their highest level in almost three years.
"The TIPS market represents a fair assessment of inflationary pressures," Simko said. Breakeven rates are the yield difference between TIPS and comparable maturity Treasuries and are a measure of the outlook for consumer prices over the life of the securities.
Dudley, in a May 19 speech in New Paltz, New York, said the central bank is falling short of its goals because unemployment is too high and inflation is likely to ease. While measures of the public's view of inflation "remain stable," Dudley said, "it is critical that we ensure that inflation expectations do not become unmoored."
Bernanke Press Conference
Chairman Ben S. Bernanke, in his first press conference April 27, indicated that the central bank won't remove stimulus immediately after ending $600 billion in bond purchases in June. At the same time, he highlighted inflation expectations as a reason the Fed might tighten credit.
"If inflation persists or if inflation expectations begin to move, then there's no substitute for action," Bernanke, 57, said following a meeting of the Federal Open Market Committee. "We would have to respond."