By Liz Capo McCormick and Sandra Hernandez
Dec. 10 (Bloomberg) -- The key to whether the Federal Reserve continues to cut interest rates after this week may hang on the wall behind economist Brian Sack's desk in Washington.
Sack, head of monetary and financial market analysis at the Fed in 2003 and 2004, uses a chart that plots forward rates measuring investor expectations for inflation in five years. The gauge is so accurate that Sack and his colleagues persuaded the central bank to use it to help set policy. The chart is autographed by former Fed Chairman Alan Greenspan.
Right now, it shows current Fed Chairman Ben S. Bernanke may have less room to lower borrowing costs than investors in Treasuries anticipate, potentially setting bondholders up for a fall. The expected inflation rate, which Sack says replicates what Fed officials use, reached 2.91 percent last week, the highest since 2004, when the central bank began the first of an unprecedented 17 rate increases. The measure was at 2.79 percent on Nov. 1.
``One of the defining features of the Bernanke Fed to date is its emphasis on measures of longer-term inflation expectations,'' said Sack, whose partners at Macroeconomic Advisors include former Fed Governor Laurence Meyer. ``The Fed is willing to tolerate short-run movements in inflation, but only as long as those movements don't appear to be dislodging long-run inflation expectations.''
Any evidence that accelerating inflation is becoming entrenched may heighten the Fed's debate as policy makers consider cutting rates to keep the worst housing market in 16 years and mounting losses in securities related to subprime mortgages from tipping the economy into recession.
Futures on the Chicago Board of Trade show a 100 percent chance the Fed will lower its target for the overnight lending rate between banks by at least a quarter-percentage point to 4.25 percent, the third cut since September. The chances are at least 50 percent that the Fed will cut again at its next two meetings, on Jan. 30 and March 18.
The gauge used by Sack, dubbed the five-year five-year forward breakeven inflation rate, suggests bets on lower Fed funds rates may be too bold. The fact that the rate stayed steady for much of the past two months as pessimism about the economy grew bolsters that view, said Michael Pond, an interest- rate strategist in New York at Barclays Capital Inc., one of the 20 primary dealers of U.S. government securities that trade with the Fed. A cooling economy typically tempers inflation concerns.
``The market, by keeping the same inflation expectations while lowering growth expectations, is implying there are inflationary pressures,'' Pond said. He held to that view even as the forward rate fell last week.
Bond investors are demanding about 1 percentage point more in yield to own Treasuries maturing in 10 years than due in two years to compensate for the risk that consumer prices will accelerate. There was no difference as recently as June.
Sack and other analysts derive the measure of inflation expectations from yields on five- and 10-year Treasury Inflation Protected Securities and Treasuries.
Five-year TIPS yield 2.15 percentage points less than five- year notes. This so-called breakeven rate is the average inflation rate investors expect over the next five years. The forward rate projects what the breakeven will be in five years, smoothing blips in inflation expectations from swings in oil prices or other events.
The five-year TIPS' breakeven rate rose to a six-month high of 2.47 percent Nov. 27, the week after oil climbed to a record $99.29 a barrel, from about 1.9 percent on Aug. 31. As crude fell to a six-week low on Dec. 6, the breakeven rate declined and Sack's measure dropped to 2.85 percent.
Investors seeking a haven from subprime-related losses have looked past signs of inflation, driving the yield on the benchmark 3 1/8 percent note maturing in November 2009 to 2.79 percent on Dec. 4, the lowest since 2004.
Bonds fell last week as President George W. Bush and Treasury Secretary Henry Paulson unveiled a plan to freeze interest rates on some subprime mortgages to prevent thousands of Americans from facing foreclosure on their homes.
The two-year note yield, which is more sensitive to changes in Fed policy than longer-term securities, rose 9 basis points to 3.1 percent as its price fell 6/32, or $1.88 per $1,000 face amount, to 100 1/32. The yield on the benchmark 10-year note climbed 16 basis points to 4.11 percent. A basis point is 0.01 percentage point.
Today, two-year yields declined to 3.08 percent and 10-year rates fell to 4.07 percent as of 1:27 p.m. in Tokyo.
`Gravity' is Clear
``The Fed has recently had to change its playbook slightly to address stability,'' said John Brynjolfsson, who runs the $11.3 billion Real Return Fund at Pacific Investment Management Co. based in Newport Beach, California. ``I don't think the Fed has a choice because the gravity of the situation domestically is clear.''
Bill Gross, who manages the world's largest bond fund as Pimco's chief investment officer, said last week the Fed may drop its target below 3 percent to support growth.
The five-year forward rate is among the Fed's ``weapons'' in modeling the economy, alongside measures of output and productivity, Brynjolfsson said.
Bernanke mentioned the forward rate in a 2004 speech. Simon Kwan, a vice president at the San Francisco Fed, singled out the measure in a 2005 report, saying it ``captures the market's assessment of how well the Federal Reserve promotes price stability in the long run.''
Bets on a half-point Fed cut tomorrow dwindled last week after the Labor Department in Washington said payrolls rose by 94,000 in November. Economists had forecast a gain of 80,000, according to the median of 82 estimates in a Bloomberg survey.
Most analysts expect the economy to gain steam through 2008. Growth will slow to 1.5 percent this quarter from a 4.9 percent annual rate last quarter, and rise to 2.6 percent by 2009, according to the median forecast in a Bloomberg survey from Nov. 1 to Nov. 8.
The dollar, which is poised to depreciate against the euro for a second straight year, is also fueling inflation concerns. The currency's drop and oil's advance pushed import prices up 1.8 percent in October, the most in 17 months.
The government may say this week that consumer prices, which set TIPS rates, increased 4.1 percent last month from this year's low of 2 percent in August and the biggest rise since July 2006, according to the median estimate of 19 economists. Food, imports and energy prices may raise inflation expectations, Bernanke said in a Nov. 30 speech in Charlotte, North Carolina.
Not Going Away
``Inflation will not go away as an underlying concern for the Fed, and that is one reason we are expecting a 25-basis- point cut, rather than 50 basis points,'' said Sarah Hewin, a senior economist in London at American Express Bank Ltd., a unit of credit-card company American Express Co. ``For now, growth takes priority.''
A Commerce Department index tied to spending patterns that excludes food and energy costs, the Fed's preferred measure, increased 1.9 percent in October from a year earlier. That matched the upper end of the 1.7 percent to 1.9 percent range the Fed projects for the next two years, according to estimates released last month.
The current level of the five-year five-year breakeven inflation rate has the Fed ``on yellow alert,'' Sack said. ``It is on their radar screen.''