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By New_Deal_democrat December 13, 2017 9:53 am
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Fed rate hikes and the Phantom Menace of inflation
With this morning's CPI report, inflation has run at a whopping 2.2% YoY. Core inflation is still under 2%. In other words, if the Fed is fighting inflation, it is a Phantom Menace.
 
While in most cases, as shown in the first graph below showing the last 70 years, the Fed has raised rates generally coincidentally with an increase in inflation, three times before, the Fed has raised rates in the face of an inflation phantasmagoria:
 
 
Note that the late 1950s and 1960s, and again in 1994 there was a Fed rate hike campaign in the face of no or virtually no increase in inflation.
 
Let's take a closer look at what happened each time. First, here are the late 1950s and 1960s:
 
 
Between the beginning of 1959 and the end of 1965, at no point did inflation exceed 2%. But twice the Fed raised rates, first from 0.75% to 4% in 1959, and again from 1% to 4% in the first half of the 1960s. The first sparked the 1960 recession; the second a near-recession in 1966.
 
Now here is 1994:
 
 
With inflation remaining in the 2%-3% range, Alan Greenspan raised rates from 3% to 6%, causing a slowdown but no recession (which interestingly helped the GOP take control of Congress in the 1994 midterms).
 
Now let's see what happened with Treasuries. FRED doesn't have shorter term rates in the 1950s, but the 10 year and archival "long term" bond data are available:
 
 
Longer term rates rose from 3% to between 4% and 5% in the first half of 1959, and thereafter trended sideways before decreasing back to 4% just prior to and during the ensuing recession. In the early 1960s, long rates remained steady at 4% before increasing in the face of yet more tightening in the 1966 near-recession.
 
Here are the 1990s:
 
 
In 1994, short and long rates rose in unison until there was a very brief very slight inversion between the 10 and 30 year bond. Thereafter all rates decreased in the face of economic weakness.
 
Now here is the present expansion:
 
 
Long rates spike immediately after the 2016 Presidential election. They have gone generally sideways since with a slight decreasing trend, slightly more notable in the 30 year bond in the past several months.
 
What is notable about these episodes is that with the exception of 1994 (perhaps because of Greenspan's persuasiveness?), the bond market never bought into any inflation scare. Further, long bonds forecast economic weakness in both late1959 and the end of 1994, although only one of the two episodes went all the way to recession.
 
My interpretation is that the behavior of the long bond since one year ago is that there is no significant inflation pressure, and since September the decline in 30 year yields is forecasting weakness next year.  
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