Just a few short months ago, it was unthinkable. A year ago, it was beyond the pale. But the extraordinary arrived yesterday when the 10-year Treasury yield fell to lows previously unseen.
The 10-year closed on Tuesday at 2.69%, a record low. The embedded message is clear: The market expects deflation, or something close to it. In the rush to find a safe haven, investors are bidding up the prices of government bonds to extreme levels. In turn, yields are falling to depths few thought possible.
The primary source of this outlook is, of course, the weak economy. "The big picture background for these very, very low Treasury rates is the weakest economy we've seen in at least a generation," Jay Mueller, senior portfolio manager at Wells Capital Management, tells BusinessWeek. "We're looking at a severe recession and the Treasury markets are reflecting that kind of an outlook."
The favored policy response for deflation is cheap money, and the Federal Reserve is moving heaven and earth to engineer just that. Indeed, the effective Fed fund rate is roughly 0.5%. But that invites the challenges that come with the so-called zero bound.
Make no mistake: We are increasingly in uncharted territory. The limited history of fighting deflation, real or perceived, ensures passage into the unknown as rates approach zero. Adding to the confusion: Some influential inflation hawks are warning that deflation isn't a clear and present danger.
St. Louis Fed President James Bullard yesterday said that further rate cuts elevate the risk of stoking deflation in the U.S. That runs counter to the widely held view that lower interest rates are a key weapon in keeping deflation at bay. Nonetheless, he's warning of the opposite, as per this report from Bloomberg News:
“I’m more concerned at these very low levels about the Japanese outcome last decade," Bullard said today in an interview, while noting that deflation isn’t an immediate threat. Japan’s central bank “went to zero” with its main interest rate, and “deflation becomes a self-fulfilling thing and you are stuck at zero.” ... “I have not been a fan of going to really low levels,” Bullard said in an earlier Bloomberg Television interview. “Why is it zero this time? I don’t quite get that, though I know some people want to go in that direction.” ... “There are limits of what you can do with interest rate policy,” he said. “We have a market conditioned to think of interest rates as the definition of monetary policy.”
Meanwhile, Philadelphia Federal Bank Reserve President Charles Plosser questions the idea that deflation is a risk. As he explains in a recent speech reported via Reuters, falling prices of late have "prompted some commentators to suggest that the U.S. is facing a threat of sustained deflation, as we did in the Great Depression or as Japan faced for a decade. I do not believe this is a serious threat."
The bond market thinks otherwise. The January '09 Fed funds futures contract is now priced in anticipation of a 50-basis-point rate cut, which would bring the target Fed funds down to 0.5%.
Additional rate cuts at this point may or may not be productive, depending on who's talking. But for good or ill, there's not a lot of mystery these days about where monetary policy is headed.