After the worst start to a year in history equities were primed for profit and St. Louis Federal Reserve President James Bullard may have provided the catalyst when he noted that the decline in oil prices may delay inflation’s long expected return to the central bank’s 2 percent target.
Mr. Bullard, who has been one of the more outspoken rake hike proponents on the FOMC, said, “With renewed declines in crude oil prices in recent weeks, the associated decline in market-based inflation expectations measures is becoming worrisome,” in a speech in Memphis, Tennessee.
Equities soared. The Dow gained over 250 points in little more than 30 minutes. The S&P 500 and the Nasdaq followed suit. West Texas Intermediate added more than a dollar to the price of a barrel to a high of $31.77 and the U.S. dollar rose against the euro and the yen.
Stable inflation expectations have been one of the standard features of the central bank’s policy statements. It appeared in every FOMC statement last year until December 16th when the bank raised the Fed Funds rate for their first time in nine years. A move Mr. Bullard supported. In the statement of that meeting ‘stable inflation expectations’ was replaced with the observation that "some survey-based measures of longer-term inflation expectations have edged down".
Is Mr. Bullard hinting that if inflation expectations fall further the Fed could temper its rate program, now predicted by its own analysis at four 0.25 percent increases by year end?
His statement, combined with the change in the Fed’s own inflation characterization, surely means that the lack of inflation is becoming a problem for the central bank.
The Fed has long cited employment and inflation as the two most important indicators for its rate policy.
The improvement in the nation’s employment situation has been the main empirical support of its new rate policy. In December 292,000 new jobs were created and the labor market performance in 2014 and 2015, along with the unemployment rate of 5 percent has been the best in more than 15 years.
Inflation, on the other hand, has been a disappointment. Annual price changes in the PCE deflator, the Fed’s preferred measure, have not been at the 2.0 percent level since April 2012. Price pressures higher in the goods chain are falling. The Producer Price Index of final demand has been negative since February last year. The prospect of many months if not years of very low oil prices can only add to the deflationary outlook.
The devaluation of the Chinese Yuan, down almost 6 percent against the U.S. Dollar since August, has been matched or exceeded by the fall of many resource and emerging markets currencies.
Canada is the United States’ second largest trading partner. The collapse in commodity prices has driven the Canadian Dollar to a twelve year low against the greenback. The cost of the many consumer goods and resources produced in America’s northern neighbor, determined by the vastly improved U.S terms of trade, will also fall, adding to the downward slant of U.S. prices.
All in all, the deflationary pressures sweeping into the United State from overseas are likely to intensify rather than abate in the year ahead.
One unusual aspect of Mr. Bullard’s remarks should be mentioned.
It was a comment by the same Mr. Bullard in October 2014 that ignited one of the steepest equity rallies in U.S. history.
On the 17th of that month the Dow opened trading at 16,118. During the day, in an interview on Bloomberg TV, Mr. Bullard hinted that the Fed could institute another quantitative easing program (it would have been the fourth), if the losses continued. The Dow never looked back, gaining over 400 points that day. By late December the average had added 12.3 percent, to close at 18,053 on the day after Christmas.
Is the Fed right to worry about the impact of worldwide deflation on U.S prices? Probably. But as Mr. Bullard said “Generally speaking, the markets and the committee are not thinking in terms of a January move.,” “As far as March, we would want to get more information and see how things play out before we make a judgment.”
The markets, however, are not waiting for the Fed's assessment.
Chief Market Strategist
WorldWideMarkets Online Trading