The bond market is telling us that inflation is coming, but the Federal Reserve keeps ignoring

The Federal Reserve is blind and the market will pay the consequences

We need to keep in mind that we are living in a Modern Monetary Theory (MMT) world where central banks have the last word to say. This week is full of speeches from various US federal reserve members. So far we can say that the one thing they agree on is that that the Fed bond-buying programme is there to stay. What they cannot agree on is whether it should be expanded or if there should be changes in the investment method. The President of the Federal Reserve Bank of St. Louis, James Bullard, today said that if the economic weakness continues, the FED would need to provide more stimulus. Yesterday, the President of the Federal Reserve Bank of Cleveland, said that she doesn't see the FED increasing the bond purchasing program. She would rather see the FED moving the focus towards longer-term bonds. Basically, what she is talking about is yield curve control, which can ultimately push the market into a liquidity squeeze as inflation rises.

Although MMT implies more money supply, in reality, it is killing the market with a gradual decrease in liquidity. As a matter of fact, what is happening right now is that the Fed is printing money to buy assets. Once these assets are in the Fed's balance sheet, it is like if they do not exist any longer: the Fed will hold them until maturity. Therefore asset prices are not high because of healthy market demand and supply; they are high because the Fed holds a big chunk them. This contributes to lower liquidity in the bond market because the Fed doesn't actively trade the assets it owns. 

Eventually, we are running the risk that the FED will be too slow to hiking interest rates if inflation rises. Theoretically, volatility should be under control because of the Fed's large balance sheet. Still, in reality, if inflation rises suddenly and the Fed doesn’t hike interest rates, the burden of repricing will fall entirely on the bond market, making it even choppier than what it is now.