- The Fed has been missing its inflation target for over two years.
- Both bond yields and expected inflation have been falling.
- Given Yellen’s weak leadership, the prospects for reflation are dim.
- The equity premium is rising.
This is how the FOMC describes its mandate with respect to inflation:
“The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.”
However the Fed has failed to achieve the 2% target for the past two and a half years despite what it believes has been “massive monetary stimulus”. The most recent reading of the targeted inflation rate is 1.5%, which is 25% below the 2% target. The consistent failure to achieve the inflation target is eroding the Fed’s credibility and is lowering inflation expectations thus raising the real funds rate which is contractionary. The Fed is tightening in the face of a weak recovery.
So far this year, the 10-year Treasury yield has declined by 70 bips from 3.0% to 2.3% while 10-year expected inflation has declined by 30 bips from 2.3% to 2.0%.
The reason that the Fed has failed to hit its target is the combination of single-digit money growth and declining velocity. The economy is in a classic Keynesian liquidity trap which requires radical policy measures. Because both Bernanke and Yellen decided to give the hawks a veto over policy, radical measures are off the table and the Fed is heading in a decidedly European direction. Ten-year German bunds currently yield less than 1% which suggests that Treasury yields may have further to fall.
It is noteworthy that as bond yields have been declining, equity yields (e/p) are rising as the market has recently declined. Thus the equity premium is both high and rising. This would be an excellent juncture to take profits from longer-term bonds and buy equities with the proceeds. While bond prices may rise further, equities are much more compelling given the current ~5.5% risk premium.