Evidence mounting that the Fed made a mistake

Bond market futures suggested at the close of business Friday that investors now expect the Fed to raise rates only once this year, and not before September. That expectation is far off from Fed members’ projections released in December, which showed that they anticipated four rate hikes in 2016.

The lowered expectations for rising rates “is consistent with the market basically suggesting that it was a policy mistake to tighten in December,” said Dana Saporta, an economist for Credit Suisse.

The most troubling signal that the Fed’s plans may not be fulfilled is falling inflation expectations.

There were already signs before the Fed’s December meeting that inflation expectations were falling. Although some members were concerned by those indicators, the minutes from the meeting show, the Fed proceeded with the rate increases anyway.

Since then, additional evidence of falling inflation expectations has presented itself, enough for several Fed members to take note.

“With renewed declines in crude oil prices in recent weeks, the associated decline in market-based inflation expectations measures is becoming worrisome,” Federal Reserve Bank of St. Louis President James Bullard said in a speech Thursday. Bullard will be a voting member of the monetary policy committee this year, starting at its meeting at the end of the month.

On Friday, New York Fed President William Dudley, also a voter, took note of falling inflation expectations and laid out why they are so important to the Fed in the current environment.

The Fed has a 2 percent inflation target. In recent months, inflation has been running closer to zero, largely because of the dramatic drop in oil prices over the past 18 months. Fed officials, however, mostly see the downward pressure of oil prices on inflation as “transitory.” They expect that if the economy keeps growing and adding jobs, inflation will pick up in time.

But “most concerning,” said Dudley, “is the possibility that inflation expectations become unanchored to the downside. This would be problematic were it to occur because inflation expectations are an important driver of actual inflation.”

In other words, inflation expectations can become a self-fulfilling prophesy.

Federal Reserve Chairwoman Janet Yellen laid out the same view at greater length in a major speech in Massachusetts in September. A key point is that the Fed does not necessarily want inflation, but that it cannot be assured that it is providing as much money as the market demands if inflation is below its target.

Inflation expectations implied by bond market prices have plunged. One frequently cited measure of bond market inflation expectations five years ahead was at its lowest mark this year since the financial crisis.

In a note posted to his personal site Thursday, recently retired Minneapolis Fed President Narayana Kocherlakota wrote that “it would be wise” for the Fed to respond to the decline in the measure by “reversing course on its current tightening path.”

Some Fed members, however, have brushed off falling market inflation expectations, on the grounds that other factors besides inflation expectations could spur investors to buy and sell the underlying bonds. Yellen and others have placed more faith in surveys of individuals or professional forecasters.

This week saw signs that those indicators, too, are heading toward decline.

A survey of consumers conducted by the New York Fed released Monday showed inflation expectations falling in December by almost a quarter percentage point from the previous quarter.

The University of Michigan Survey of Consumers, the most closely watched such survey, showed that inflation expectations for the next year cratered from 2.7 percent to 2.4 percent (average expected inflation always runs slightly higher than the Fed’s inflation target).

Longer-term inflation expectations edged up from 2.6 percent to a still-low 2.7 percent, but Saporta warned that the data was subject to future downward revision in light of stocks falling. “It may be premature to say that consumers are taking this in stride,” she said.

Overall, the picture is one in which the Fed’s key premise — that inflation expectations are stable — is at risk of falling apart, and that the Fed may have signaled too much tightening.

The Fed is not expected to raise rates at its January meeting, which will be held Jan. 27-28. The question is whether it will do so at its meeting in mid-March.

Some officials are taking the market signals in stride. San Francisco Fed President John Williams said Friday that he does not pay attention to daily market fluctuations, according to Reuters.

Dennis Lockhart, president of the Atlanta Fed, said in a speech Monday that he “will be watching for any signs of a more definite downshift” in expectations.

“As of now, I’m not overly alarmed by recent readings,” he added. “I believe inflation expectations remain reasonably well anchored in the neighborhood of our target.”