First, inflation is still low.  There was mention of inflation picking up in the latest Fed statement, but the increase is mostly a result of higher oil prices.  Longer-term inflation expectations remain relatively stable.  The 5-year breakeven rate shows that investors expect annual inflation of 2.07% over the next five years, which is down from 2.47% a year ago.

Second, the labor market is still incredibly weak.  The chart below from Calculated Risk shows just how ugly the jobs situation is compared to past recessions.

Low inflation and a weak job market is a recipe for loose monetary policy.  But monetary is way beyond “loose” at this point and is more reflective of “emergency” accommodations.  Several regional Fed presidents have spoken out publicly in opposition of the current monetary policy stance, but the most vocal of these individuals don’t get a vote until 2014.

Below I’ve charted out the different monetary policy stances of current and future voting members of the Federal Open Market Committee (FOMC).   The scale is subjectively based on policy meeting minutes, public speeches, and media interviews.

“Dovish” members prefer more accommodative monetary policy (lower interest rates) and are more tolerant of higher inflation.  “Hawkish” members favor tighter monetary policy, which translates to higher interest rates, and are less tolerant of higher inflation.

Of the six permanent voters, there is a distinctly dovish stance, and only one of the four rotating voters this year (Lacker) has voted against leaving interest rates at exceptionally low levels until at least late-2014.  Next year Bullard will replace Lacker as the designated hawk, but the other new voters in 2013 still have a dovish tilt.

As you can see, the big shift occurs in 2014 with the rotating voters likely to favor tighter policy.  In addition, it is possible that Chairman Ben Bernanke, the orchestrator of today’s unprecedented monetary accommodation, will be replaced that year by Obama or Romney.

The make-up of voters this year and next suggest that interest rates will remain low, but it’s difficult to imagine the incoming voters in 2014 keeping zero-interest-rate-policy in place past that year.  The caveat here is that low rates would stay in place if the U.S. dipped into recession again.

One last somewhat related chart…this one shows the stock market’s reliance on Fed stimulus during the last three years.

It’s a little spooky how the Fed has propped up the stock market.  Hopefully in 2014 the U.S. economy and corporate earnings will be strong enough that stocks can stand on their own when the Fed takes away the crutches.

Peter Lazaroff

St. Louis, MO

www.acrinv.com/blog