Oil, CPI, Inflation Expectations and the FOMC

The FOMC statement was largely taken as "dovish", with rallies in EM, SPX, TIPS breakevens and a re-steepening of the curve. But a closer look at the statement, as pointed out by the FT's Krishna Guha (http://blogs.ft.com/money-supply/2009/11/04/final-reflections-on-the-fed-statement/), suggests that the market may have misinterpreted the statement. Guha points out that the committee, whilst retaining the key language on rates being kept low for an "exceptional" period of time (generally assumed to be six months), they attached conditionality and outlined the criteria that would push them to hike in the next six months.

Specifically:
- low rates of resource utilisation (i.e. - the unemployment rate).
- subdued inflation trends.
- stable inflation expectations.

Now, while the unemployment rate is unlikely to come down anytime soon, the latter two conditions are not as certain to remain unbreached. Firstly, the liquidity-driven rally across risky assets this year - along with the infatuation many have with Chinese commodity demand - have resulted in commodity prices retracing a large amount of their 08H2 sell-off. In particular, the Oil price is one of the main drivers of headline CPI, and the base effects are about to become extremely large. For example, if the Oil price stays at its current level of $80 into year-end, its year-on-year increase will be just under 150%. The (albeight naïve) chart below highlights the coming surge in headline CPI towards a 3%-handle by January, and beyond if Oil continues to march on (which is not inconceivable if the naked liquidity trade continues).
While core inflation has been trending lower (in response to the size of the output gap), and the market knows that it this that is more important, the weight of positioning in the "lower for longer" trade may be unable to withstand such an acceleration in the headline number. Indeed, most will remember the ECB's reaction function to the march of Oil into July 2008 and the associated collateral damage across asset classes: it is clear that the potential for a "rush to the door" is there.

Secondly, the Oil price has affected inflation expectations before, and it will affect them again. The below chart of the University of Michigan's 5y Inflation Expectations survey, and shows that last year these rose above their historic 2.75%-3% range. There has been much research that concludes that surveys of inflation expectations are highly correlated with coincident inflation numbers, and it would be unwise to expect no effect upon these gauges as the headline begins to accelerate.
The Fed also pay significant attention to market-based inflation measures, such as TIPS. As the deflation scare took hold in 08Q4, TIPS break-even inflation rates collapsed, but have since recovered much of their ground. The outright TIPS are not as useful for determining expected inflation due to issues of liquidity, financing and inflation risk premia, but the forward-starting TIPS do not suffer from all of these problems (though, they are still not perfect). The below chart shows that 5y5y forward breakeven inflation has returned to the top of the range generally considered to be "anchored" - of 2.25%-2.75%. Indeed, breakevens widened another 6bps in the aftermath of the FOMC statement.
Finally, the USD has been in a downtrend and is approaching the levels at which last year caused concern for policymakers - indeed, Gold has surpassed its prior peak, and a break of 1100 would likely lead to further USD selling more broadly. The key issue for policymakers is the extent to which this sell-off begins to affect inflation expectations via the feedback loops into Commodities and back again - much as was the case in the first half of 2008. Yesterday's reaction across asset classes (as discussed above) was particularly telling in this respect, and the risk is - that with the conditions for a policy move having been set - that the USD sell-off vs other currencies and Commodities accelerates and forces the Fed's hand, just as in the second quarter of 2008. In such a scenario, the risk-reward must be to hold shorts at the front-end of the curve around six months out. As ever, the Fed's reaction function will be to first downplay an acceleration in inflation, but such moves usually result in yet more USD selling which exacerbates the problem. Perhaps short the Dollar and short Equities is an effective way to play what will be an eventual self-defeating acceleration of the liquidity play.