In October 1979, Federal Reserve Chairman Paul Volcker declared war on inflation, committing the Federal Reserve to the task of lowering inflation without simultaneously damaging economic growth. By any definition, the results have been a stunning success. The past 20 years of prosperity were interrupted only twice by brief, shallow recessions, while the rate of inflation has declined from 14% to 1%. The current level of inflation (1-3%) is commonly defined as price stability, which is achieved when inflation is so low that it no longer affects household and business economic decisions.
In pursuit of its economic growth mandate, the Fed's primary weapon is short-term interest rates. When economic stimulus is required, the Fed aggressively purchases short-term Treasury securities that it pays for through an increase in the monetary base. Such activity creates new bank reserves and forces down the federal funds rate allowing banks to lend funds more inexpensively. The art of central banking revolves around the strategy timing. The central bank must take counter measures to slow the monetary base growth before it translates into an increase in inflation. The long lag time between policy changes and market impact makes the Fed's job only more difficult.
Now that inflation finally appears to be defeated, a new concern has crept into strategy discussions. With interest rates already low, how would the Fed create sufficient additional economic stimulus if needed? Furthermore, since interest rates cannot go below zero, if prices were actually declining (deflation), then real interest rates would effectively be rising and the Fed would be powerless to help.
After the FOMC meeting on May 6, the Fed commented on a slight risk of "an unwelcome substantial fall in inflation." These statements were disseminated over the next six weeks, and were reiterated after the June 25 FOMC meeting. Widespread press attention followed, during which time the comments were construed to highlight a significant deflation risk. The impact on the bond market was dramatic. The interest rate on the 10-year Treasury note fell 80 basis points from its already low level down to 3.09%.
On July 23, Fed Governor Ben Bernanke stated that the Fed had been misinterpreted. The markets and the media had substantially overstated the concerns that the FOMC had intended to communicate, he said. "To my mind, the central import of the May 6 statement is that the Fed stands ready and able to resist further declines in inflation," he added. Governor Bernanke said that he agrees with Milton Freidman that, in the long run, inflation is a monetary phenomenon.
In statements following the August 12 FOMC meeting, the Fed toned down the language describing the risk of an unwelcome fall in inflation by removing the previously-included term "substantial." It added the following verbiage: "In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period." The combination of these two minor statements further should convince the bond market that deflation is highly unlikely.
What should a bond investor conclude from this information? My answer is that the acceptable range of inflation at the Fed has changed. A 1% floor is too close to zero so the floor has been raised, probably to 2%. For the time being, the Fed will probably try to contain inflation between 2% and 4%. After 24 years of preaching that inflation is Public Enemy #1, the Fed is faced with a re-education problem.
What are the implications for interest rates? As investors become convinced that inflation could hover near the 3% level, yields will be re-priced accordingly. Under this scenario, it would not be surprising for the 10-year Treasury to yield between 5% and 6%. Long duration bonds, of course, will suffer meaningful price depreciation as interest rates tick upward.
Treasury inflation protected securities, favorite hedges against inflation, unfortunately, are not likely to perform well in this environment either. As other interest rates have declined, the price of TIPS has risen, causing the real yield of the TIPS to closely track the decline in non-TIPS yields. It is our opinion that this relationship will continue to hold as interest rates rise. This will cause the price of TIPS bonds to fall which should more than offset the benefits of their inflation protection.
Until these adjustments are completed, investors would be well advised to maintain short maturities and to forego the extra yields that longer maturities offer.