Tuesday, August 13, 2013

The FOMC is running out of excuses to maintain current policy

The retail sales measure from the Commerce Department survey came in below expectations today with 0.2% month-over-month change vs. 0.3% expected. Given that the numbers missed the forecast, why then did treasuries sell off sharply after the release?

10y treasury yield (source: WSJ)

The answer is that while retail sales growth has not been spectacular, it is sufficiently strong for the Fed to begin reducing its securities purchases shortly. Sales ex-autos were up 0.4% (auto sales are volatile and other recent indicators of auto sales have been strong.) The year-over-year ex-auto retail sales number is historically on the lower end, but falls within the 2.5%-5% range that some view as stable.

Given that the consumer is such a large part of the GDP, some economists are already revising their GDP forecasts up. The FOMC now has only one key potential showstopper: the ultra-low inflation rate scenario.  As James Bullard pointed out in his June speech, inflation measures were collapsing earlier this year (see post), raising the specter of deflationary risks. If that trend were to continue, the Fed would go into a holding pattern.

But inflation indicators in the US seem to have stabilized. Commodity prices have bottomed out (for now), as copper bounced (see post) and energy prices remain elevated.

CRB BLS Spot Index of 23 commodity markets (source: CRB/barchart)

Moreover, market-implied inflation expectations have risen since the dip earlier this summer.

10 Year TIPS/Treasury Breakeven Rate
(implied inflation expectation; source: Ychart)

With deflation no longer a high probability near-term threat, the FOMC has run out of excuses. Unless the labor market suddenly takes a material turn for the worse this month, we should see the beginning of the end for QE3 shortly.

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