The latest chart porn out of the Atlanta Fed:
What you see here is a steady decline, from August through November, in the expectation that the Fed will begin tightening monetary policy before 2012. But expectations have reversed trend since then, and the market now thinks that Bernanke will begin increasing the federal funds rate (ever so slightly) above the 0-0.25 target range as soon as the FOMC’s meeting on August 9.
And these expectations have been climbing since the start of the week — a bit more detail from Dow Jones:
November 2011 fed-funds futures, at Thursday’s settlement, priced in a 64% chance for the Federal Open Market Committee to raise the funds rate to 0.5% at its meeting on Nov. 1-2. That is unchanged from Wednesday, but up from a 58% chance on Tuesday, and a 50% chance on Monday. As recently as Dec. 6, the November fed-funds contract priced in only an 8% chance for a 0.5% rate.
Also from the Atlanta Fed, here’s an updated look at inflation expectations:
They have climbed impressively since the Jackson Hole speech, and certainly this was one of the Fed’s intended effects. Combined with the recent stretch of favorable economic indicators, it’s easy to see what’s happening here: surprisingly stronger economy + higher expected inflation = Fed tightens earlier than previously thought.
Even so, remember that inflation itself remains quite subdued. And as our colleagues at Money Supply recently noted, although inflation expectations are higher, they remain at comfortable levels. It is less the case that inflation is now primed to surge upward to threatening heights than that the probability of further significant disinflation — or outright deflation — has simply been reduced (not to trivialise the importance of this).
What happens next obviously depends on how robust the recovery turns out to be. Truthfully, we have a feeling the futures market is getting a bit ahead of itself here. The US economy still has a lot of spare capacity, while housing prices remain depressed and employment growth lags. Much deleveraging remains to be done. The economy also remains extremely vulnerable to additional negative shocks.
So we question whether the economy will have improved enough by next autumn to meaningfully change these realities and convince the Fed that it’s time to start tightening.
But hey, we’re not forecasters, so who knows?
Related links:
Bloodbath of the bonds – FT Alphaville
Everyone should relax about rising nominal yields – FT Alphaville
Bernanke and the real costs of QE2 – FT Alphaville
The return of (very cautious) optimism – FT Alphaville