This post is a guest contribution by Asha Bangalore* of The Northern Trust  Company.

The employment report of February summed up the current economic situation as showing small positive improvements from the prior month, with many worrisome aspects still in place. Lest we forget other notable developments in the market place; these pictures are on our watchlist among many other economic and financial variables we follow. Inflation stories are floating around, particularly in relation to the size of the Fed’s balance sheet. As usual, there are two camps – one that fails to see inflation as a major concern given the fundamentally weak status of the economy, and the other focusing on the explosion of the Fed’s balance sheet since late-2008.  Inflation expectations are important, no doubt. The market measure of inflation expectations (10-year US Treasury note yield minus 10-year TIP rate) was 2.13% on February 26, down from a high of 2.43% on February 3 and was trading at 2.21% on March 5 (see chart 1).  Essentially, these numbers imply there is no inflationary threat around the corner.

The Fed’s balance sheet is frequently cited as a source of inflation in the months ahead; it has grown to $2.26 trillion from $2.0 trillion in the mid-2009 (see chart 2) but it has yet to move significantly higher than the level recorded in late-2008. Roughly 50% of the financial accommodation provided is being held in the form of excess reserves.  Therefore, until excess reserves are converted to credit, the inflation scare is a mirage.

The effective federal funds rate closed at 11 basis points on February 24 and was 17 basis points on March 5. One day’s mark is not a trend, but the March 5 reading of the effective federal funds rate has caught our attention. It is being explained partly as a technical issue. It appears that if this is the beginning of new trend, the arbitrage opportunity of banks is gradually vanishing into the horizon. Is this another aspect of the Fed’s exit strategy in operation? Is it a one-off event? The answer is unclear, but we are watching closely.

Source: Northern Trust – Daily Global Commentary, March 8, 2010.

* Asha Bangalore is vice president and economist at The Northern Trust Company, Chicago. Prior to joining the bank in 1994, she was consultant to savings and loan institutions and commercial banks at Financial & Economic Strategies Corporation, Chicago.

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