The first order of business in repairing the economy is reestablishing a stable rate of inflation, ideally a small dose just above zero. There's inherent danger in targeting higher inflation, but it's a necessary evil at the moment, and there are signs that the effort is working.
Exhibit A is the yield spread between the nominal and inflation-indexed 10-year Treasuries. The spread is considered the market's inflation forecast. Although no one should confuse this outlook with perfection, it does reflect market sentiment to a degree and it's also monitored by the folks at the Federal Reserve, among countless other statistics.
As our chart below shows, this spread continues to exhibit an upside bias, and in the current climate that's encouraging. As of last night's close, the Treasury market is forecasting a 1.3% inflation rate for the next 10 years—up from virtually zero late last year. Certainly the extreme lows of last November and December appear to be history, at least for the moment. That's heartening because it suggests that the market's modestly encouraged that deflation's threat is passing.
Insuring that deflation doesn't take root has been and remains the priority for stabilizing the economy and laying the foundation for recovery, as we've been discussing in recent months, including here and here. The good news is that progress in this battle continues to accumulate, and the above chart is but one example.
A more general measure of the improvement in the reflationary war is suggested by today's update on new orders for durable goods, which posted a healthy seasonally adjusted rise of 3.4% last month—the first monthly rise since last July.
The jump in new orders, although not consistently positive across the board, was broad enough to suggest that the gain wasn't a statistical fluke. A few examples: new orders for machinery advanced more than 13% last month while new orders for computers and electronic products climbed nearly 6%. Excluding defense department-related items, new orders increased 3.9% in February.
No one should read too much into this report, of course, as one month could easily be statistical noise. After six months of declines, durable goods were due for a pop even if the recession roars on. Deciding if it's the start of stability vs. a pause in the ongoing contraction will take time and a fair amount of corroboration from other economic and financial measures. But one implication is that businesses are starting to react to lower prices by taking advantage of the bargains.
In other words, we can't dismiss the prospect that the massive liquidity injections engineered by the Fed and Congress are starting to work. Once there's more confidence on that front, it's time to adjust monetary policy and begin soaking up all the excess dollars floating about. Timing is always a gray area of course, but it's certainly prudent to go on heightened alert at this point.
Consider the latest news from Britain, which reported that inflation took a surprising jump higher last month. Consumer prices climbed 3.2% for the year through February, raising fresh questions about whether monetary policy in England is too loose. Alas, it's unclear if the inflation news is a sign of things to come or just a "hiccup along the way" to more falling prices generally, as one economist tells Bloomberg News. Of course, with many economists forecasting more economic weakness for Britain, the inflation report raises the specter of stagflation.
In short, there's still plenty of volatility harassing the global economy. The idea that the worst is behind us is tempting, but it's not yet convincing. Stay tuned.