Investors are betting with Ben S. Bernanke that surging food and energy prices won’t accelerate U.S. inflation, allowing him to maintain easy money.
Their forecast shows in gauges of long-term price expectations, including the difference between 10-year nominal and inflation-indexed Treasury bonds, which fell to 2.36 percentage points Feb. 4 from 2.41 points Jan. 5. While pressure from commodity costs may cause a spike this year to what Pacific Investment Management Co.’s Anthony Crescenzi considers a warning threshold of 2.75 points, the spread won’t persist there or higher without strong job growth, Crescenzi said.
That means the Federal Reserve chairman probably won’t raise benchmark interest rates from near zero in 2011 because of higher consumer prices, Crescenzi predicted. So investors may want to purchase two-year Treasury notes, which yielded 0.74 percent on Feb. 4 compared with 0.54 percent Jan. 28, or buy Eurodollar contracts that expire within the year, he said.
“Headline inflation is beginning to have a greater influence on monetary policy, but not yet at the Fed,” said Crescenzi, who helps manage $1.2 trillion at Pimco in Newport Beach, California, as executive vice president. The central bank “remains anchored or hinged to the core rate,” which excludes food and energy costs.
The Fed “appears to be awaiting economic growth that is stronger than 3.5 percent, a more significant decline in unemployment and rising expectations for inflation,” Bob Doll, chief equity strategist for fundamental equities in New York at BlackRock Inc., said in a Jan. 31 note. “In our opinion, we are still quite a bit away from such an environment.”
Wan-Chong Kung, who helps oversee $198 billion at Nuveen Asset Management in Minneapolis, said she’s skeptical actual inflation will turn out to be as high as the 2.36 percentage-point 10-year breakeven rate investors are pricing in.
“Breakevens are vulnerable to downward pressure based on perhaps a reassessment of the more realistic prospects for inflation in the United States,” said Kung, senior vice president and portfolio manager. “The dominant driver” of core inflation “will still be wage inflation.”
High U.S. unemployment will keep salaries in check, limiting the biggest influence on broader prices, Crescenzi said. Bernanke’s strategy of focusing monetary policy on the core rate contrasts with European Central Bank President Jean-Claude Trichet and Bank of England Governor Mervyn King. They are signaling growing discomfort with prices, prompting investors to anticipate faster interest-rate increases in the euro area and U.K.
Bernanke and his colleagues on the Federal Open Market Committee stuck to their plan to expand record monetary stimulus by affirming on Jan. 26 their $600 billion in Treasuries purchases through June. Their lack of alarm showed that day in the FOMC statement, which acknowledged rising commodity prices while stressing that longer-term inflation expectations were stable, and “underlying inflation” was still on the decline.
Prices of corn, wheat, heating oil and cotton each have gained more than 5 percent this year, spurred by demand in emerging-market countries including China and by adverse weather including bitter cold and severe snowstorms in Europe and North America.
The Fed’s most closely watched inflation gauge, the Commerce Department’s core personal consumption expenditures price index excluding food and energy, rose 0.7 percent in December from a year earlier, the smallest advance since records began in 1959.
While prices of some “highly visible” items such as gasoline have “significantly” increased recently, “overall inflation remains quite low” and wage growth has slowed, Bernanke said in a Feb. 3 speech at the National Press Club in Washington. “These downward trends in wage and price inflation are not surprising, given the substantial slack in the economy.”
Average hourly earnings rose 1.7 percent last year, slowing from 1.8 percent in 2009 and 3.4 percent in 2008, according to the Labor Department. U.S. employers added 36,000 jobs in January, the smallest gain in four months, while the jobless rate fell to 9 percent from 9.4 percent as the number of people without work and size of the labor force declined.
Unemployment has persisted at or above 9 percent since May 2009; the last such stall was from March 1982 to September 1983. During that period, core inflation declined to 5.2 percent from 6.9 percent and was 3.7 percent at the end of 1985.
Fed policy makers forecast core inflation of 0.9 percent to 1.6 percent this year and overall inflation of 1.1 percent to 1.7 percent, based on November forecasts. Updated projections from their Jan. 25-26 meeting will be released Feb. 16.
The Fed’s asset purchases sparked a backlash from top Republican lawmakers and foreign officials, who said the program would cause a dangerous increase in inflation. Investors broadly don’t agree. A Fed gauge of market inflation expectations in the five-year period starting in five years was 2.95 percentage points on Feb. 2, compared with 3.14 points on Jan. 5.
So far there’s little pressure for salary gains at some companies. “We don’t have any wage inflation at all,” David Farr, chief executive officer of Emerson Electric Co., a St. Louis-based maker of data-center equipment and thermostats., said on a Feb. 1 conference call. Denver-based Apartment Investment & Management Co., which owns or runs units serving 500,000 residents, sees a “gradual and halting recovery” in the economy,” where “labor costs will be subdued,” Chief Executive Officer Terry Considine said on a Feb. 4 call.
With unemployment so high in the U.S. and in the euro region -- where the jobless rate was 10 percent in December -- households don’t feel confident enough to seek higher wages that would spur demand for goods or require companies to raise their own prices, said Karen Ward, a global economist in London at HSBC Holdings Plc. That means workers will spend more of their salaries filling up their gas tanks or buying groceries.
“By year-end, rising cost pressures are more likely to have dampened activity than to have led to a persistent rise in underlying inflation,” Ward, a former Bank of England economist, said in a report last month. If central banks agree, then “keeping policy accommodative is the right policy response.”
While China is accused of increasingly exporting inflation, it may not find a home in developed nations, said Ethan Harris, head of developed-markets economic research at Bank of America Merrill Lynch in New York. That’s partly because imports from China account for only about 2 percent of gross domestic product in the U.S. and euro area, he wrote in a Jan. 28 note.
“The pass-through of rising core and wage inflation in the emerging markets is likely to have a small impact on developed-world inflation,” Harris said.
Some investors are wary. The Fed “is looking at inflation trending down; the rest of the markets are looking at inflation starting to pick up a bit,” Michael Pond, co-head of interest-rate strategy at Barclays Capital Inc. in New York, said Feb. 3 in a Bloomberg Radio interview on “Bloomberg Surveillance” with Tom Keene. While the Fed won’t start raising rates, it soon may change its January view that underlying inflation is “trending downward,” economists at Societe Generale SA said in a Feb. 2 note to clients.
Central bankers who monitor core inflation do so because food and energy tend to respond to shocks in weather or geopolitical tensions, which are temporary and immune to monetary policy. Officials who prefer to monitor headline prices watch for repercussions as workers and companies seek compensation for the higher costs.
The policy of ignoring commodity prices also has an increasing “number of shortcomings” because the acceleration in emerging-market growth and likelihood of global warming mean such inflation may become more regular and persistent, said Luigi Speranza, head of inflation and fiscal economics at BNP Paribas SA in London.
Trichet and King may be less sanguine than Bernanke because, unlike the Fed, they target headline inflation and have no full-employment goal, said Laurent Bilke, global head of inflation strategy at Nomura International Plc in London. The euro and sterling have been rising against the dollar because their central banks “seem much closer to monetary tightening than is the Fed,” according to Beat Siegenthaler, a currency strategist at UBS AG in Zurich. The pound is up about 3 percent versus the dollar so far this year, and the euro is up 1.5 percent.
The U.K. five-year breakeven rate rose to 2.87 percentage points on Feb. 2, the most since May last year. A similar measure in Germany, the benchmark for euro-area debt, rose to 1.64 points, more than double its August level.
While Trichet signaled on Feb. 3 that the ECB had no immediate plans to raise its benchmark interest rate from 1 percent, the central bank forecasts inflation will stay above its goal for most of this year. “Very close monitoring is warranted,” he said in Frankfurt at a press conference.
European inflation accelerated to a 2.4 percent rate in January, the fastest since October 2008, breaching the ECB’s goal of just below 2 percent for a second consecutive month. U.K. inflation rose to an eight-month high of 3.7 percent in December from a year earlier, breaking the Bank of England’s 2 percent target for a 13th month.
Foreign inflation means “we may well have to respond” by “keeping domestically generated inflation lower,” Bank of England Deputy Governor Charles Bean said in the Feb. 2 edition of the Western Mail newspaper. JPMorgan Chase & Co. said the next day it now expects a rate increase in May rather than August. Bank of England policy makers meet Feb. 10.
“The commodity-price shock is perceived as different here,” said Bilke, a former ECB forecaster. His predictions: The Bank of England will lift its 0.5 percent key rate a quarter point in August, and the ECB will raise its rate by the same amount in September, while the Fed keeps the federal funds rate close to zero until 2013.
The effects of commodity inflation in developed countries will be more like a small wave than a tsunami, said Steven Bell, chief economist at London-based hedge fund GLC Ltd. and a former U.K. Treasury official. “I don’t see inflation as a big issue,” with the possible exception of the U.K., he said. “I’m in the ripple camp.”