The one thing we have come to expect from the Federal Reserve is that if it tries something that doesn’t work, it will do more of it.

The Fed has made clear that falling inflation expectations are the top of its worry list. Falling prices reduce profits, discourage investments, and make debts harder to service. The market reasons that if inflation drops, the Fed is more likely to cut rates. That’s why the yield on Treasury Inflation Protected Securities dropped like a stone at 8:30 am EST in the US, after the US government announced a slightly lower increase in March consumer prices than the consensus forecast.

Prices excluding food and energy rose just 0.1% in March (a 1.2% annual rate) vs. an expected 0.2% (a 2.4% annual rate). That is a small difference, but enough to change Federal Reserve policy were it to persist.

The lower-than-expected Consumer Price Index reading was due almost entirely to a change in the government’s method for calculating apparel prices, and the market should have shrugged it off. The fact that it moved the market tells us a great deal about the Fed’s obsession with reviving inflation expectations and the market’s hair-trigger sensitivity to the Fed’s every wink and nod.

A drop in TIPS (or so-called “real” yields) usually cheers the equity market. The S&P 500 rose 0.35% while the small-cap Russell 2000 gained 1.4%, led by consumer discretionary stocks. That should give Asia a tailwind at its Thursday opening.

The market is gaming the Fed, probably with the Fed’s encouragement. The Fed figures that if yields fall in response to lower inflation expectations, the low-inflation problem might correct itself as lower interest rates stimulate economic activity. That isn’t happening, though, and I don’t think it will.

At the end of 2018, inflation expectations took a ratchet turn downwards, and the Fed morphed from hawk to dove in response. The downshift in inflation expectations is of a specific character, as the chart below makes clear:

The market’s measure of inflation expectation is the difference between the yield on inflation-indexed Treasuries and ordinary Treasuries. That yield margin is the “breakeven” inflation rate, namely the inflation rate at which inflation-index Treasuries will pay the same total return as ordinary Treasuries. It usually moves in tandem with commodity prices.

As the chart shows, the slope of the line (the sensitivity of breakeven inflation to commodity prices) didn’t change at the end of 2018, but the intercept of the line (its so-called alpha) shifted downwards – and hasn’t come back.

Another way to view the same data is through the regression equation of 10-year breakeven inflation on commodity prices. Commodity prices snapped back but inflation expectations did not. The error in the model went sharply into the negative.

Why is this happening?

Under the rubric “limits to leverage,” I argued earlier this week that cheap money had generated a lot of dodgy deals but little economic gain. More leverage corresponds to lower return on equity for constituent companies of the S&P 500 as well as the small-capitalization Russell 2000, both in the aggregate and within each of the nonfinancial sectors.

More accommodation by the Federal Reserve won’t stimulate economic growth. It won’t even make mediocre returns at the company level look good by levering up the balance sheet. The downshift in inflation expectations appears to denote a downgrading of the economy’s prospects on part of investors.

Part of the problem, to be sure, is that the Fed’s measurement of inflation is unreliable. As noted, Wednesday’s benign reading began with a shift in inflation measurement. Other components of the Consumer Price Index, might bounce up later this year, as lower interest rates for home mortgages buoy the housing market. Shelter comprises 40% of the Consumer Price Index, so a hiccough in the inflation rate can’t be excluded.

Still, the inability of the US economy to turn cheap money into output at the level of individual firms suggests sluggish growth and somewhat lower US earnings for 2019.

Europe and Asia look somewhat more attractive than the US, largely because Chinese growth is accelerating.  I’ll explain more tomorrow.