Abnormal Expectations

The Federal Reserve yesterday told us what we already suspected was coming. Economic growth will remain sluggish, according to the Fed’s new core projection. Real GDP for all of 2011 will rise by 1.6% to 1.7%, the central bank predicts, down from its June estimate of 2.7% to 2.9%. Next year’s real GDP is expected to deliver slightly better results in the 2.5% to 2.9% range, but that estimate has also been trimmed from June’s 3.3% to 3.7% guess.

The dysfunction of the U.S. economy, in other words, will be with us for the foreseeable future, If there’s anyone left who doesn’t understand this discouraging outlook, Bernanke set the record straight once again in yesterday’s post-FOMC press conference.
True to form in these troubled times, the Treasury market’s inflation outlook still waxes and wanes with the crowd’s expectations for the macro trend. Or does the causality flow the other way? In any case, it’s no surprise that the recent rally in the stock market coincided with a pop in the market’s inflation expectations, as implied by the yield spread on the nominal 10-year Treasury Note less its inflation-indexed counterpart. (For some background on why inflation expectations and the stock market are joined at the hip these days, see my post here.) As of yesterday, Treasuries’ inflation prediction settled at just over 2.0%, up from the recent low of 1.72% on September 22. Since that date, the stock market (S&P 500) has rallied 9.6% through yesterday. The prospects of higher inflation remain tightly linked with expectations for growth. That’s abnormal, but for the foreseeable future it’s likely that this abnormality has legs.

It’s also a relationship that offers some empirical support for the market monetarists and their recommendation for targeting higher levels of nominal GDP as a better mandate for monetary policy. But if the Federal Reserve is entertaining the concept, it wasn’t obvious in Bernanke’s press conference yesterday. Then again, maybe an artful reading between the lines suggests otherwise. “Bernanke’s no idiot,” writes Scott Sumner, an unofficial leader of the market monetarist camp. “I have to assume he privately favors more stimulus, and is considering options for December or January. And I think he’s counting down the days until the new crop of regional Fed presidents comes on to the FOMC, and wondering why Obama left 2 Board seats empty.”
Perhaps, but talk is cheap. Expectations, on the other hand, remain dominant, and for compelling reasons, as economist David Beckworth recently discussed. By that standard, the outlook remains precarious. The 10-year Note’s inflation outlook is higher, but just barely. For the moment, it’s easier to make the case that gravity is still in control of the trend this year for inflation expectations. Perhaps the recent pop in expectations heralds a new era, but that looks unlikely with the 10-year TIPS yield turning slightly negative in recent days.
Once you factor in the ongoing turmoil in Europe, well, it requires a potent strain of optimism to see a material change on the upside for growth and a fall in the forces of disinflation/deflation. Meantime, Bernanke stands at the ready. “We are prepared to take further action,” he said yesterday. “We’ve already taken quite a bit of action but we are prepared to do more and we have the tools to do more if that’s appropriate.”
By some accounts, it’s appropriate NOW. But this is by no means a universal view. If inflation expectations take another tumble, however, Bernanke’s hand may be forced no matter the political repercussions.