Money and Financial Markets

Economic Trends, September 2002 | Go to article overview

Money and Financial Markets


The Federal Open Market Committee's August 13 statement indicated that the balance of risks for the economy tilted toward economic weakness, a change from its previous statement that economic weakness and inflation were evenly balanced. How do the financial markets view the current balance of risks? Put another way, do market participants see a 1.75% federal funds rate or an M2 growth rate of more than 5% as a sign of inflation?

Over the long term, the answer seems to be no. One market measure of expected inflation, the spread between yields on 10-year nominal Treasury bonds and 10-year Treasury inflation-indexed bonds, has fallen. In late May, the spread implied expected inflation exceeding 2%; it now implies values closer to 1.75%. In the short term, the answer again appears to be no. A measure of expected inflation over the next 30 days, derived from surveys and Treasury bill rates, suggests a rate of only 2.4%

A less favorable indicator of inflation risk comes from the gold market, where prices have increased 21% since April 2001 and 12% since the beginning of this year. However, the price of gold is not an infallible sign of inflation because often it is affected by specific market factors such as central bank sales or jewelry demand.

A rise in gold prices often reflects a flight to security when the economic or political outlook becomes uncertain, but other measures of risk in the financial world do not point to uncertainty. The TED spread, the yield difference between eurodollar deposits and Treasury bills, often picks up on such concerns because it measures credit risk at international banks without reflecting exchange rate risk; it remains very low. In the domestic market, the yield spread between 90-day commercial paper and three-month Treasury bills also remains quite low. …

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