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Does the dovish Fed pause carry inflationary implications?

Timely insights from portfolio managers and industry experts on key financial, economic and political issues.

The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness.

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      By Stewart D. Taylor, Investment Grade Fixed Income Portfolio Manager, Eaton Vance Management and Jason DesLauriers, Investment Grade Fixed Income Trader, Eaton Vance Management

      Boston In 2010, a group of respected economists and market strategists published an open letter to Ben Bernanke, chairman of the Federal Reserve at the time, warning that quantitative easing (QE) would lead to dollar debasement and inflation.

      Nine years later, headline inflation is still having trouble accelerating beyond 2%. Why has this period been so different from what these accomplished investors and economists expected?

      In our opinion, instead of moving into hard assets, the liquidity from QE found its way into financial assets and housing, inflating those markets and unleashing tremendous bull markets. Our greatest fear is that this flow may be in the early stages of a reversal in which liquidity flows from financial to real assets, creating inflation in the real economy.

      We believe the Fed's recent decision to pause its rate hiking cycle, while prudent given the global economic slowdown, further increases the odds of a meaningful turn higher in inflation in the next 12-18 months.

      Inflation is, by its nature, a late-cycle development. It generally continues to rise after the economic cycle peaks and turns lower. Moreover, when it does begin its late-cycle rise, it often increases very quickly.

      This makes sharply rising inflation hard for economists and central bankers to anticipate. It also complicates the job of a central bank, as it is infinitely more difficult to tighten policy into an economic cycle that is turning lower. At this point in the economic cycle, we believe the Fed should become more vigilant, not less. Yet, this appears to be the course the Fed is steering.

      A change in inflation policy?

      Current monetary policy treats 2% core personal consumption expenditures (PCE) inflation as both the target and the upper limit. Led by the San Francisco branch, the Fed may be on the verge of changing the substance of this policy.

      If adopted, the new approach would average inflation, allowing it to rise above 2% following periods when it has been below 2%. The logic is this symmetrical approach will allow additional discretion when dealing with periods of subpar economic growth. Assuming for a moment that precisely measuring and predicting inflation in a dynamic economy is possible (it's not), moving from an already high 2% target rate to a symmetrical or averaging policy will allow the Fed even more discretion when dealing with inflation.

      We think this is a bad idea for a number of reasons. In previous posts, we have discussed in detail the problems with the 2% inflation rate, and the difficult time central banks have wresting control back once inflation becomes embedded in the economy. We have also discussed the enormous political will power it takes to force high inflation back to nominal levels. In our opinion, policies designed to tolerate higher inflation degrade the Fed's inflation credibility and increase the risk of higher inflation. Tolerance of higher inflation is not only bad for U.S. households, but also for foreign investors of Treasurys and other U.S. assets.

      Inflation outlook

      We have made the case in past blog posts that the long-term trend in inflation bottomed along with energy and commodity markets in late 2015. We also believe that the recent decline in energy prices will push the near-term outlook for headline consumer price index (CPI) lower over the balance of the year, but that it will have little impact on either core CPI or long-term inflation dynamics.

      One of the missing components of inflation has been rising wages. We have made the case that demographics, and the failure of many of the more closely watched economic series to account for the fast-changing role of benefits as compensation, have hidden much of the strength in wages. Now, a growing number of the traditional indicators are showing growth. For instance, average hourly wages for February grew at a 3.4% annual rate, the fastest rate since early 2009, according to the February employment report.

      Lessons of Paul Volcker

      Paul Volcker led the Fed from 1979 to 1987. His memoir -- Keeping at It, The Quest of Sound Money and Good Government -- is a must read for anyone concerned with central banks and monetary policy. His ability to withstand extreme political and public pressure to stop raising rates, and consistently doing the "right thing," hopefully provides a roadmap for the current Fed should inflation actually become threatening again.

      Bottom line: While headline inflation may continue to fall due to the decline in crude oil, the larger inflationary forces continue to build. In the meantime, many markets are priced for lower inflation, and the Fed seems less willing to be proactive in preventing inflation.