When the Fed Talks Price-Level Targets, Markets Should Shudder

Neither bonds nor equities are pricing in much of a premium for the prospect of faster inflation, increasing the risk of a correction.

The Fed's new inflation debate has markets on edge.

Photographer: Michael Nagle/Bloomberg

Despite its best efforts, the Federal Reserve has been unable to get the rate of inflation to its target of 2 percent. So now, some policy makers are talking about a new strategy known as price-level targeting. Markets better hope it doesn't come to that.

The difference between an inflation target and price-level targeting may seem like semantics, but they are very different. Under the former, the Fed would do what it takes until the rate of inflation reached 2 percent. Under the latter, it would essentially allow inflation to rise above the 2 percent target for an extended period to make up for the times when it failed to meet that level.

According to a presentation by Federal Reserve Bank of St. Louis President James Bullard, inflation is running about 4.6 percent below the target. If price-level targeting were used to reduce the gap, the Fed would have to commit to allowing inflation to run "hot" at 2.5 percent for almost 10 years. U.S. bond markets, though, are not discounting the potential for that to happen, and are instead pricing in almost no premium for the prospect of faster inflation. It’s the same for equities, raising the risk of a market correction if it were to happen.

Growing Gap Between Price-Level Index and Trend  

Historically, when inflation ran above target for more than two years, the bond market yield curve -- or the difference between short- and long-term rates -- inverted, and a stock market correction of 5 percent to 10 percent occurred. Given the current gap between actual and targeted inflation, it wouldn't be out of the question to see an even larger decline in financial markets as inflation risk premiums get repriced.

To get an idea what it means for markets when inflation runs above target for a long time, take a look at the U.K. There, inflation was running from 3 percent to 5 percent, yet the Bank of England cut interest rates and extended its quantitative easing program. Although the cumulative total return for the FTSE 100 has been 145 percent since 2009, U.K. stocks have dramatically lagged behind the performance of the S&P 500 Index, Germany's DAX and Japan's Nikkei.

U.K. Normalized Stock Market Performance vs. Other Markets

Another potential side effect of running inflation hot is negative real interest rates. Real rates in the U.K. have dropped since 2009, falling further below those in the U.S. This divergence can be explained by growth expectations that have turned positive for the U.S. but more negative for the U.K. The problem with negative real rates is that many seen them as an expression of expectations for slower growth ahead driven by faster inflation, which is a negative for corporate earnings.     

U.S. and U.K. Five-Year Real Interest Rates   

The U.S., for example, has had periods of inflation that were much higher than the current 2 percent target: 1983 to 1990, 1994-2000, and 2003-2008. Equity investors suffered through corrections of 5 percent to 8 percent in each of those instances toward the end of the economic cycle.

U.S. Stock and Bond Returns During Above-Target Inflation

With various indexes showing that current U.S. financial conditions are about the loosest they've ever been, the Fed has an opportunity to think carefully about changing its approach to inflation. Low inflation risk premiums show the bond market isn't too concerned about the course of Fed policy. But that could change and inflation risk premiums could surge if the Fed were to decide to switch to a price-level targeting regime, becoming a significant headwind for U.S. markets.

Inflation Risk Premium    


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