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When Will Expected Inflation Hit 2.5%?


The Fed may remain accommodative for a very long time.

MINYANVILLE ORIGINAL Just when most people were getting used to the idea of QE3, yesterday the Fed announced QE4. When will the madness stop? In the Fed's latest announcement it mentioned the "projected" inflation rate. This article will take a look at the TIPS expected inflation indicator to determine how long the Fed can remain accommodative under the new guidelines.

Let's start from the beginning. For those interested in long-term inflation data, a good source of material is How Much Is That in Real Money? by John J. McCusker. Mr. McCusker goes all the way back to the Colonial times of 1665 and comes up with an annual inflation index. The McCusker Index was 106 on December 31, 1665. By December 31, 1913 the index was at 119. So in the 248 years before the advent of the Federal Reserve, inflation went up by 12.26%. This equates to 0.05% on an annualized basis.

The Federal Reserve was created on December 23, 1913. One of the objectives of the Federal Reserve is stable prices. The definition of stable, according to Webster's dictionary, is "not changing or fluctuating." From December 31, 1913 to October 31, 2012 (99 years), the inflation rate has gone up by 2,213.17%. This equates to 3.23% on an annualized basis.

Since the Fed has been such an abject failure with respect to stable prices, on January 25, 2012 Chairman Bernanke set the "target inflation rate" to 2%. This Orwellian-sounding term has worked out very well for the Fed. The majority of financial articles now reference the 2% inflation rate which the Fed aspires to without noting the absurdity of targeting a 2% inflation rate under the guise of "price stability."

While the amount of additional funny money was widely expected, what did come as a surprise was that the Fed announced monetary policy would remain accommodative until either the unemployment rate reaches 6.5% or "inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2% longer-run goal, and longer-term inflation expectations continue to be well anchored."

The key word is projected.

Since September 2008, the maximum inflation rate was 3.87% in September 2011. Probably the most common way of determining the expected inflation rate is to take a constant maturity bond yield and subtracting from it the corresponding TIPS rate. The five year expected inflation rate on September 30, 2011 was 1.5%.

So what are the TIPS saying the expected inflation rate is right now?

Here are the expected inflation rates over next x years by way of the TIPS indicator:

As you can see the 10 year and 30 year rates are already implying an expected inflation rate of over 2.5%. The 20 year is just about there.

When will the 5-year rate hit 2.5%? Remarkably enough, despite all the various Fed stimuli, the 5-year TIPS has had an implied inflation rate of below 2.5% for every single day since July 19, 2008!

It must be noted that the Fed's new inflection points of 6.5% unemployment and 2.5% short term inflation affect the monetary policy. As for the QEs, the Fed was a bit more vague. However, now that the Fed has brought the short term projected inflation rate tool officially in its arsenal, it may not be too much of a stretch to suggest that perhaps the short term inflation rate may be used in determining when to stop the QEs as well.

The lowest TIPS rates in history for the 10-year note and 30-year bond were -0.87% and 0.24% on December 10, 2012. While the nominal low for notes/bonds occurred on July 25, the expected real return (i.e. the TIPS rate) was even lower because the expected inflation rate increased more than the yields on the 10-year note and 30-year bond.

In other words, on Monday the 10-year note and 30-year bond were the most overvalued in history.

In summary, the expected inflation rate for the 5-year TIPS hasn't hit 2.5% in over four years despite all the various quantitative easings. The Fed may be in easing mode for a long time. Plan accordingly.
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