Inflation, not jobs, may hold key to Fed exit

June 6, 2013

It’s that time of the month again: Wall Street is anxiously awaiting the monthly employment figures – less because of its interest in job creation and more because of what the numbers will mean for the Federal Reserve’s unconventional stimulus policies.

As one money manager put it all too candidly: “Bad news is good news in this market lately because it keeps the Fed buying bonds and interest rates low.”

Given that the Fed is the closest thing the world has to a global central bank, what happens at the Federal Open Market Committee doesn’t often stay in the Federal Open Market Committee. Indeed, emerging markets have become increasingly volatile since Fed Chairman Ben Bernanke said policymakers might curtail the pace of asset buys in coming months.

Everyone is focused on whether there has been substantial improvement in the labor market, the Fed’s stated pre-condition for abandoning QE3. However, something else has been happening to the other side of the central bank’s mandate: inflation has been falling steadily. Over the past 12 months, the Fed’s preferred inflation measure has slowed to just 0.7 percent, the smallest gain since October 2009 and well below the Fed’s 2 percent target.

Pablo Goldberg, global head of emerging markets research at HSBC securities, says this is really the primary factor economists should be watching:

While there has been a lot of talk about growth and employment, it will ultimately be the course of inflation that will determine room to remove stimulus. HSBC Economics believes that although the FOMC could reduce the rate of asset purchases, depending on how the labor market evolves this summer, low inflation provides an argument for maintaining the pace of asset purchases for longer than would otherwise be the case. Therefore, our expectation is for the FOMC simply to maintain the current ($85 billion per month) pace of asset purchases for the rest of the year.

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