Why Traders Are Angry: "The Fed Is Modeling Distortions It Helped Create"

Must read thoughts from Richard Breslow, a former FX trader and fund manager who writes for Bloomberg

The Federal Reserve Bank of San Francisco released a paper yesterday with a decidedly dour take on why market measures of inflation expectations remain in the tank. It’s a very relevant debate to have for several reasons.

It contradicts, or at least introduces important additional challenges, to the explanation made by Fed Chair Yellen in her already dovish speech just last week. More importantly, rate hikes won’t be more than symbolically attempted until the Fed gets a lot more comfortable with the issue, or decides to assume it away.

The current Fed view is that market-based measures are (hopefully) skewed by supply and demand realities caused by the small size of available TIPS and decreasing “insurance” premiums demanded to protect against future inflation. The latter always struck me as funny as it assumes, by definition, faith in Fed policies.

The alternative argument asserts the decline can’t be modeled without concluding that, even with all of the above, actual intermediate-term inflation expectations are falling notably.

This decline is not likely to be short-lived, but should be resolved over the medium- to long-term,” the San Francisco Fed said, creating a conundrum for policy makers if these new models prove to be correct.

There goes the “it’s all oil’s fault and that’s just transitory” mantra right out the window. Frequent mentions of dollar appreciation are not coincidental. Currency wars are always in the eye of the beholder.

It’s important to realize that the inexorable buying of debt securities by global central banks has so distorted markets that no one can actually know what’s implied by market pricing: other than monetary policy run amok. Just this week several central banks warned they have plenty more ammunition to ease further. After all, its done so much good.

Wave after wave of price insensitive frenzy and disregard for risk make these debates merely an academic exercise. But, scarily, one that directly influences policy.