At the June FOMC meeting, the Fed released its economic forecasts
Usually, at the March, June, September, and December FOMC (Federal Open Market Committee) meetings, the Fed releases its economic forecast for the current year and the upcoming two years. One of the nice things about this is that you can see how its forecast has changed over time. In this part of this series, we’ll look at how the Fed’s forecast for 2014 inflation has changed over the past few meetings.
The Fed uses a different inflation measure
The Fed prefers to use the Personal Consumption Expenditure (or PCE) Index as its measure of inflation over the Consumer Price Index, which is more familiar to most people. There are a few differences between the two—the Personal Consumption Expenditure Index is updated more frequently and takes into account things like employer expenditures on healthcare and substitution between goods. The Consumer Price Index (or CPI) is based on what people say they’re buying, and it’s adjusted less frequently. As a general rule, the CPI overemphasizes housing, while the PCE overemphasizes healthcare. There just isn’t a perfect inflation indicator.
The Fed bumps up its forecast for 2014 inflation slightly
In December of 2012, the Fed was forecasting that inflation would remain around 1.6% to 2.0%. By the June 2014 meeting, it had taken down that number to range between 1.5% and 1.7%. This was an increase from the March 2014 forecast of 1.5% to 1.6%. It’s important to understand the Fed’s mandate regarding inflation. Its job isn’t to minimize inflation, but to promote price stability. The Fed has a dual mandate—to manage inflation and to stimulate the economy in order to promote full employment. The Fed fears deflation, and given that we’re at the lower bound for interest rates, a decrease in inflation actually increases real interest rates. So the Fed will try to keep the inflation around 2%. As a practical matter, for the average American, a 3% inflation with a 3% wage growth feels much more comfortable than no inflation and no wage growth.
Implications for mortgage REITs
For REITs like Annaly (NLY), American Capital Agency (AGNC), MFA Financial (MFA), Hatteras (HTS), and Two Harbors (TWO), low inflation means low interest rates for the foreseeable future. While the Fed may decide to remove accommodation through decreasing asset purchases, it will probably maintain the Fed funds rate at 25 basis points for the next few years. This means that while the yield curve may steepen, it isn’t going to do a parallel shift for quite some time. This puts a limit on how much interest rate risk the REITs actually have. Investors who wish to make directional bets on interest rates should look at the iShares 20 year bond ETF (TLT).
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