Monday September 12, 2005 - 20:56:17 GMT
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US Inflation Expectations Waiting For Take Off
Just when it looked like there was no end to the bond market conundrum (a flat yield curve leaning toward inverted), along comes Katrina and voila the curve is steepening. And so it should as the fallout from Katrina is showing up in energy prices...sure only gasoline is above pre-Katrina levels, but it is safe to say the supply-shock from Katrina is real and all else being equal (like not releasing SPR and IEA supply) the hurricane is supporting prices. As the Fed ponders the impact on the real sector from the hurricane as in possibly pausing after hiking September 20 (odds of pause a week from Tuesday has dropped significantly), markets sense the short end of curve may have an anchor in Katrina while inflation could see second round impulses from energy prices.
If the Fed puts a pause into play in the FOMC statement, as the insider press suggested will happen in the event of a hike September 20, the market will see that a pause is not only feasible but likely at the November and December FOMC meetings when post-hurricane data will be piling up. While no one knows what the data will show, markets are sure to assume the worst...jobs, GDP, retail sales and sentiment...even if temporary. And if the Fed's hands are tied ahead by Katrina, the potential for inflation to accelerate (expectations especially so) will rise. Catching up at a later date with a half point rate increase won't be enough to keep long nascent inflationary expectations from rising. And as is already evident, the yield curve is already steepening.
While not the primary component driving Fed policy decisions, it is nonetheless significant...political pressure. Congressional leaders from both parties have urged a pause in Fed tightening and the now infamous Bush-Greenspan luncheon last week where Katrina and presumably the September20 FOMC meeting were discussed. Would it be pure conjecture to assume the President would like the Fed Chairman to push the pause button on rate hikes?
Even the notion of the Fed pausing for one to two meeting will likely pressure the dollar, and in turn this could to inflation expectations.
Meanwhile there is the US Treasury supply story that will put upward pressure on yields. First the government is increasing the deficit by financing supplemental spending bills with debt issuance...so far roughly= $60bln approved for Katrina. Then there is the question of insurance companies selling assets to finance claims. In this case we suspect (as happened in hurricane Andrew) insurance companies will be selling Treasuries (longer-dated maturities) to raise funds to meet claims.
If the curve steepens as I have suggested, the property market bubble could go pop in fairly short order, and at the very least notions of household wealth could change in a hurry as could household consumption between falling prices (real estate) and all those homes bought with ARMS and other more exotic forms of financing (IO's) see monthly mortgage payments increase.
Surely the Fed knows the risks of being perceived as behind the curve on inflation and perhaps Katrina will cause the Fed to embrace the conundrum in the bond market for fear the cure is worse than the disease.
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