Former New York Mayor Ed Koch loved to ask his constituents “How am I doing?” One can only speculate as to an answer if Federal Reserve Chairman Ben Bernanke posed a comparable question on matters of monetary policy to his constituency of dollar holders.
A clue as to our thinking on a provisional answer can be found in the following analysis. The first displays the yield curve at two points in time: Friday’s close, and a previous manifestation from a year earlier, August 11, 2005. As the chart illustrates, the arc of money’s price has become slightly inverted relative to the upward-sloping curve of 12 months previous. On Friday, the yield in a 30-day Treasury bill (a proxy for “cash”) was 10 basis points higher than a 10-year Treasury Note. That’s in sharp contrast to a year ago, when a 10-year Treasury commanded a 100-basis-point premium over a 30-day T-bill. Progress may be elusive, but change is incessant.
Now consider the trend in the core rate of inflation, which is computed by excluding the prices of energy and food. A year ago, for the 12 months through June 2005, core CPI rose by 2.0%. A year on, core CPI advanced by 2.6% during the past year through June 2006. That may not mean much to the man in the street, but in central banking terms the upward shift is dramatic and signals that pricing pressures are mounting.
In other words, the central bank has been raising interest rates, but without a material impact on slowing inflation’s rise. Bernanke and company realize that their attempts at prevailing has proved insufficient on altering core CPI’s course, and have admitted as much in FOMC statements this year. Plan B is telling the world that while the rate hikes haven’t put a ceiling on core CPI, elevating the price of money will still prevail because it will slow the economy, which in turn will do what rate hikes have not yet accomplished: end if not reverse core CPI’s upward momentum.
The slightly negative yield curve does in fact suggest that economic growth will slow. The question is whether slower growth will produce the proverbial rabbit from the Fed’s hat in the form of core CPI that no longer rises or declines? Getting from here to there remains an open debate, and history provides at best a mixed message.
The next clue in this all-important sage comes on Wednesday, when the Labor Department publishes July’s consumer price indices. The consensus forecast, according to TheStreet.com, is that core CPI will remain elevated by unchanged from June at 0.3%. If accurate, that would be better than 0.4%, although it will hardly reduce the pressure on the Fed to convince an increasingly skeptical Wall Street that it’s still in control of inflation trends. The best-case scenario would be a fall in core CPI, in which case Bernanke’s credibility goes up a notch, if only until the next monthly inflation update.
Alas, the Fed’s power (which is primarily one of managing expectations) now hinges on each new data point. This is a setback for the central bank, and for investors generally. To be sure, the markets are far more concerned these days with geopolitical events, which dominate the daily news. Watching the evolution of monetary policy is comparatively a sleepy sport that’s comparable to watching glaciers melt.
Nonetheless, keeping an eye on a small drip can pay off in the long run. Another drop comes tomorrow. And so, our glass is out, although we’re still not sure if it’s half full or half empty. Clarity invariably quenches our thirst, but the slaking takes time.