After months of thinking the Fed’s next move would be a rate increase, the market is suddenly toying with the idea of another cut.
Inflation seems to have buckled under the heft of a global economic slowdown. Crude-oil prices are down 27 percent from their July peak. The dollar has rallied, throwing more dirt on inflation — though the temporary government takeover of Fannie Mae and Freddie Mac could change that. Even gold, investors’ friend when prices rise, has declined.
Market fears about prices have nearly vanished. The gap between the yield on 10-year Treasury Inflation-Protected Securities and the 10-year note has shrunk to less than 2 percent, the lowest since 2003. This suggests investors see consumer-price inflation averaging less than 2 percent annualized for the next 10 years, well within the Fed’s comfort zone.
As recently as June, the federal-funds futures market, where traders bet on future Fed moves, priced in three rate increases by year’s end. Now it is pricing in no chance of a rate increase. At times last week the market began to price in a slim chance of a cut this year.
August’s jump in unemployment makes a cut seem more likely. Further labor-market weakness would hurt the economy, while keeping wage gains in check, preventing the sort of wage-price spiral that let inflation get out of hand in the 1970s.
A different kind of -flation, deflation, seems to be gaining more currency these days. In a note to clients that roiled financial markets last week, Pacific Investment Management Co. managing director Bill Gross said tighter credit standards were forcing homeowners, banks and investors to cut back on debt and sell assets to raise cash, a trend that is deflating asset prices now and could lead to broader deflation later.
He said prices for U.S. homes, stocks and bonds combined were down 10 percent from a year ago, a rate associated with the Great Depression.
Deflation may not sound bad, considering food, gasoline and other prices are still high. Widespread deflation can delay purchases and investments as people assume prices will keep falling.
It is too early to worry about that. The job market would have to get much weaker, pushing wages lower, to set off the sort of deflationary alarm bells that rang at the Fed back in 2003, when it slashed its key rate target to 1 percent, notes Morgan Stanley economist DavidTHGreenlaw.
Many economists, and some Fed policy makers, think rates are low enough. If the Fannie-Freddie takeover results in lower mortgage rates, the Fed might have one less reason to lower its target rate.
Still, expectations are shifting. The two-year Treasury note yield is nearly as low as fed funds. Breaking below it historically signals expectations of a Fed rate cut. The futures market, on the other hand, still expects the Fed to raise rates in the spring. That may be too soon.