Fed Inflation Outlook Lowers Long Bond Yields While Debt Ceiling Jitters Raise the Short End

Today’s Fed meeting closed with no rate increase (as expected).   The real action was in the inflation outlook in the accompanying statement.  Earlier this year, the weak inflation environment was described as “transitory” with anomalies such as cell phone billing plans cited as factors.  Today’s statement indicates a “puzzled” Fed wondering why a strengthening job market is not spurring inflation.  It seems that the Fed is wondering why the “new normal” is not conforming to traditional economic metrics.  The Fed’s preferred inflation index is stuck at 1.4%  so markets are interpreting this stance as potentially staving off any increases for the rest of the year.  The assumed December rate increase is now in doubt.  The Fed also continued telegraphing their other major policy issue, the “normalization” of the balance sheet, i.e. trimming their holdings of mortgage bonds and treasuries.   The statement said that normalization will start “soon” (September is assumed as the Fed probably doesn’t want to start increasing bond supply in the summer months).   The wild card is the debt ceiling.   The Treasury is estimated to run out of extraordinary measures to keep paying government obligations.    Congress has a end of September deadline to increase or risk roiling capital markets worldwide.   The Fed would most likely not start the process in this case.   Already, the 3 month Treasury yield has spiked to its highest yield since 2009 on default worries. Stay tuned. By David R. Pascale, Jr. , Senior Vice President at George Smith Partners.