Whom are you going to believe? The markets or the Federal Reserve?
 
Minutes of the Dec. 16-17 meeting of the Federal Open Market Committee released Wednesday suggest the policy-setting panel has greater confidence in its forecasts of inflation than that of the markets. That’s even though the Fed has consistently overestimated the strength of the economy and price pressures.
 
Specifically, the FOMC contrasted the plunge in market-based measures of future inflation expectations with those derived from surveys and econometric models. Since the markets’ determination contradicted that of the surveys and models, the committee discounted the former and concluded it would take more time and study to determine which was right.
 
Participants in the confab attempted to hash out whether the drop in anticipated inflation was real or an artifact of markets that are supposed to provide a window into expectations. The most prominent is that for Treasury Inflation Protected Securities, or TIPS.
 
As the economist Irving Fisher posited more than a century ago that interest rates consisted of a “real” return plus a compensation for the effect of future inflation. The real and inflation components of interest rates used to be discernable only in retrospect after gauges such as the consumer price index were calculated and published.
 
That changed with the introduction of inflation-indexed securities. The U.S. was relatively late to offer TIPS in the late 1990s, more than a decade after the U.K. and other sovereigns had started selling their versions. TIPS pay a real interest rate with their principal adjusted for the rise in the CPI.
 
Thus, the real and inflation components of Treasury yields could be deconstructed. By subtracting the real yield on TIPS from that of comparable-maturity regular Treasury securities, one could infer the market’s expectation of the inflation component of long-term interest rate from what came to be called the “TIPS spread.”
 
The FOMC cast doubt that it was an apples-to-apples comparison, however. Despite both TIPS and regular Treasuries being full faith and credit obligations of the U.S. Government, the latter have unique attributes, notably being the single most liquid and accepted financial instrument on earth.
 
That is worth a premium price, which lowers Treasuries’ yields a few basis points (hundredths of a percentage point.) In turn, that shrinks the TIPS spread correspondingly, and thus reduces the implied inflation premium.
 
But that effect is trivial compared to the collapse in inflationary expectations in the past half year.

That time span, not coincidentally, encompasses the time since crude oil prices have collapsed by half, from over $100 a barrel to under $50.
 
Back in mid-June, when oil peaked, the 10-year TIPS spread --representing the implied inflation forecast for the next decade -- was around 2.2%. That could be discerned from the 10-year T-note yielding about 2.60% and the comparable TIPS yielding about 0.40%.
 
By Wednesday’s close, the benchmark 10-year Treasury yielded 1.99% while corresponding TIP yielded 0.39%. That gives a TIPS spread of 1.6%, suggesting a sharp drop of 60 basis points in longer-run inflation expectations.
 
The FOMC doesn’t believe it. That’s because forecasts derived from consumer surveys and mathematical surveys don’t corroborate the decline that drop in inflation actually will happen.
 
That 1.6% inflation forecast also is significantly below the Fed’s target of 2%. Granted, the Fed’s favored measure isn’t the headline CPI but the personal consumption expenditures deflator. Leaving aside the mind-numbing differences between the two gauges, the important thing is the PCE deflator tends to run a few tenths of a percentage point lower than the CPI.
 
And the Fed focuses on “core” prices, which omit food and energy prices. Consistent with that, the FOMC minutes emphasized the impact of the drop in the cost of oil and gas was expected to be “transitory.”
 
What that means isn’t entirely clear. Does it imply that, if crude still is down around $50 a year from now, the annual change in energy costs will be nil? Or does it mean oil and gas prices are apt to rebound, if not all the way back to their peaks, then maybe half-way?
 
Whatever the case, the consumer surveys and models say the current low prices won’t last and inflation will revert to 2%-plus. That’s the Fed’s forecast and FOMC members’ expectations that the fed funds rate will rise to 3.75% in the long-term. The target federal-fund’s rate is now zero-0.25%.
 
Mr. Market avers. Not only does he see lower inflation ahead, he also sees a much more subdued liftoff in the fed funds rate.
 
According to the Chicago Mercantile Exchange’s Fed Watch web site, the fed-funds futures market was giving just under even-money odds of a hike to 0.50% by the July 29 FOMC meeting. The more likely timing of the initial hike is the Sept. 17 get-together, to which the futures gave a probability of 63%.
 
That’s also the timing seen by the Goldman Sachs economics team led by Jan Hatzius. Their forecast for a later liftoff than seen by the consensus reflects the chance inflation will fall significantly lower, perhaps as low as 1% on the core PCE, the Goldman economists write. That could delay the first rate hike until 2016, they conclude.
 
The Goldman team point out their forecast for inflation is well below the consensus and the FOMC. But it is in line with that of the market.
 
So, whom are you going to believe? The determination of the market, which is the distillation of millions of opinions of players who have put money on the line? Or survey respondents, for whom talk literally is cheap, or the Fed’s impersonal computer models?
 
The market has surprised the best and the brightest in bringing down interest rates and inflation expectations. That includes the Fed.