Tuesday, December 17, 2013

Inflation measures point to Bullard's "small taper"

Inflation measures provide key data points for the Fed in deciding on the timing and the magnitude of taper. Last week's PPI and today's CPI numbers continue to show a fairly benign inflation environment.

Source: Econoday

However CPI and similar measures tend to be "lagging" indicators, motivating the FOMC to also look at market-based inflation expectations. In particular the committee tracks TIPS-based break-even figures, which also remain subdued.

Source: Ycharts

When adjusted for the so-called "risk premium" using a calculation performed by the Cleveland Fed (see paper), expectations of future inflation are even lower. What may be of concern for the Fed is that even 10 years out, expectations are comfortably below the 2% target rate.

This bodes well for Bullard's "small taper". The idea is to begin reducing purchases soon in recognition of improving labor markets, but move cautiously to avoid declines in inflation.
James Bullard: - A small taper might recognize labor-market improvement while still providing the committee the opportunity to carefully monitor inflation during the first half of 2014. Should inflation not return toward target, the committee could pause tapering at subsequent meetings.

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