×

Is Bernanke Behind the Curve When it Comes to Inflation?

Federal Reserve Chairman Ben Bernanke heads to Capitol Hill on Wednesday with yet another charge to fend off—that the central bank's loose monetary policies are ignoring a looming inflation risk.

Federal Reserve Bank Chairman Ben Bernanke.
Ted S. Warren
Federal Reserve Bank Chairman Ben Bernanke.

While stocks keep roaring along, bond markets appear to be in the early stages of pricing in inflation, perhaps not now but at a point in the future where recent tame yields no longer will be satisfactory.

At Wednesday's congressional hearing, the central bank chairman is apt to face a series of questions about when he will begin pushing for an exit strategy from the $2.3 trillion balance sheet expansion during the quantitative easing program. Statements by Fed governors Tuesdayindicate that there is sentiment within to change gears.

"The yield spread is telling the whole story: Bernanke is blind to all things inflation," says Michael Pento, senior economist at Euro Pacific Capital in New York. "The bond market is taking off the rose-colored glasses. They see it."

Spreads between the yields of 2-year and 10-year notes are hovering around record proportions, a trend that historically can mean that risk appetite as well as inflation concerns are growing.

Bernanke will speak to Congress as the Fed is halfway through the second leg of QE, which has seen the central bank buy up another $600 billion of Treasurys. He'll need to provide some assurance that he is not tone-deaf to monetary policy concerns.

"They've just got to make sure that our money retains its reliable store of value, and that in my opinion is being compromised," Rep. Paul Ryan, head of the House Budget Committee, told CNBC in a live interview. "I'm not talking about high interest rates, I'm just talking about not zero."

Indeed, with the nascent economic recovery still on shaky ground as employment and housing continue to lag, Bernanke is unlikely to face pressure to take any dire steps. However, at least a tacit acknowledgement that the Fed is conscious of rising inflation concerns likely will be required.

Bond investors again made their sentiments known Tuesday, greeting a three-year auction with modest demand even though that is the part of the yield curve the Fed is targeting. Should this week's auctions follow suit, it would put a dent in the buy-what-the-Fed-is-buying mentality that has taken root since the central bank's vigorous intervention in the post-crisis financial markets.

"Markets want to see the FOMC recognize the improvements in the economy since the program commenced," Mike O'Rourke, chief market strategist at BTIG in New York, wrote in a note to clients. "It is not a reversal of policy that is necessary, just a sign that the Central Bank is anchored in the same reality in which the market is. Otherwise, the speculative forces go haywire; some would say they already have."

In addition to watching rates, inflation hawks also cite record highs in commodities as indications that the Fed's policies are keeping the US dollar at reduced levels compared to other currencies and thus driving up prices in energy, metals and grains.

"The market may be beginning to think that the Fed will stop at nothing to create inflation and may also be reacting to the news that the Fed has now replaced China, and by mid-year will have displaced both China and Japan combined, as the largest holder of US government bonds in the world," David Rosenberg, economist and strategist at Gluskin Sheff in Toronto, wrote in an analysis.

Price inflation has shown up in commodities and is causing concern in developed countries such as China and Brazil. But with US inflation only around 1.5 percent, some think it's too early to worry about it being a problem.

So-called core inflation as measured by the Consumer Price Index, stripping out food and energy prices, also is showing few signs of major inflation.

Doves on inflation, then, insist that the recent rise in rates, which has seen the benchmark 10-year Treasury note gain more than 1 percentage point since mid-November, is not a major worry.

"There's been a big increase in the breakeven inflation number in the market, really ever since the end of 2008, no question," says Robert Tipp, chief investment strategist at Prudential Fixed Income in Newark, N.J. "But the move we've seen so far in the big scheme of things should be seen as a normalization."

Few, then, think that the Fed is likely to change course anytime soon, despite pressure it may get from Congress.

"The yield curve is not screaming out that the Fed is behind the curve" on inflation, says Zach Pandl, economist at Nomura Securities in New York. "The yield curve has steepened but not to a level that would be of immediate concern to the Fed. The fact is the recovery is still proceeding somewhat slowly."

But Pento, of Euro Capital, worries that if current trends continue and the Fed does not show a willingness to act, it risks not only higher rates but also a reaction across asset classes to stocks.

"I have a stopwatch I'm watching now. I think the chances of a correction are very high," he says. "If yields rise and you get a sharp pullback in the currency, you're going to have a very sharp decline. The risks are much more elevated than before."