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Inflation Hits Fed Target, More “Normalization” On The Way?

Today’s CPI numbers again demonstrate the link between oil prices and interest rates. Annual CPI hit 2.1%, which is just above the Fed’s stated “target” of 2.0%. Note that employment is already at the Fed target. The leading CPI category was gasoline at over 9.0%. Interestingly for real estate, housing costs were up 3.6%. The 10 year Treasury hit 2.43% today after the release, after dropping to 2.40% yesterday morning. Note that the Fed’s preferred inflation measure, PCE (Personal Consumption Expenditure) Index is at 1.4% as of November. But the CPI report definitely indicates an upward trend in prices. Let’s see if it’s sustained. A key component of the unprecedented and ultra-accommodative monetary policy from the Fed in the wake of the financial crisis has been quantitative easing via increasing the balance sheet. The Fed purchased about $80 billion of bonds per month during much of 2010-2013 which comprised of Treasuries and Mortgage Backed Securities. Although the bond buying stopped, the Fed is still holding those bonds and reinvesting the proceeds as they mature. Recent statements by Fed officials indicate that the Fed may be ready to start disinvesting (selling), by not reinvesting as bonds mature. This will lower the Fed’s balance sheet which also dovetails with stated policy goals of the incoming administration. One official indicated the right time would be when short term rates reach 1.0% or at the time of the next 0.25% increase in the Federal Funds Rate which has a potential to happen in June 2017. Again, the Fed is sending out trial balloons to avoid another “taper tantrum” when Bernanke abruptly announced the end of the purchase program and spooked markets. The effect of the increased supply on market and economy will be closely watched. It will be interesting to see when the “old normal” returns, i.e. short term rates near 3.0% and the Fed balance sheet back to its “normal” size of about $1 trillion (down from $4 trillion today). stay tuned.           David R. Pascale, Jr.