A key tenet to my outlook is the expectation of low interest rates through 2012's ARM reset, but commodity inflation could force Fed action toward the contrary.
The consumer will just have to bear the burden of high food and energy costs, but the Fed won't react unless an increase in bank lending stifles Core CPI, threatening hyperinflation. Consensus will recognize the next six months as a stagflationary environment. As we near the June expiry of QE2, the U.S. Dollar Index (DXY) will have softly approached 74 (and likely 71) thanks to a stronger EUR, but it will rally from there, along with JPY. At this point, the Fed must keep its foot on the gas -- using its portfolio interest and maturity proceeds -- to provide monetary support throughout fiscal consolidation, then apply fiercely countercyclical force when the economic upswing persists.
In the wake of Wednesday's entry about my secular economic outlook, I thought I'd discuss some near-term challenges to my timeline. In the end, I'm on the lookout for confirmation of a null hypothesis. In other words, once I've formulated an opinion, I look for evidence of the contrary to help me identify the risk or the breakdown of my convictions. Commodity inflation could dramatically change the trajectory of my outlook. Since it's all the rage with oil back over $100 and an agricultural boom (food shortage) ein force, I'll start there.
Many have criticized the Fed for focusing on Core, as opposed to Headline, CPI in its measure of inflation. Commodity inflation is undoubtedly hurting the consumer. Remember, however, that deflation and inflation are the Scylla and Charybdis of this crisis. Further, with ZIRP and QE already in force, deflation is the scariest monster.
I opine that inflation -- to a point -- might just be another penance for the consumer to bear in retribution for his overleverage. (It's compounded by the fact that the government can consciously dole out such penance, and it hits the bottom 30% of earners & retirees the hardest, while aiding banks. That's an unsavory travesty.)
This turns ugly if it persists for too long or if it evolves into hyperinflation, which would require an earnest rally in Core CPI (ex-food & energy). A spike in bank lending is the most probable catalyst of such hyperinflation. The Fed has tools to combat such a spike, at least more confidently than they can combat deflation at this point: It's tested reverse repos; it can raise the interest rate on excess and required reserve balances; and so on.
Am I too casual in my expectation that the Fed can absorb excess liquidity? No. The Fed engineered this recovery when it souped-up banks with the risk-free carry trade, and it can perpetuate this mechanism or reverse it with the same market intervention. However, as we approach that point where the consumer collapses beneath food and energy inflation, how can the Fed control a runaway in these specific inputs without pushing the core inputs into deflation?
Well, the DXY is resting on a trendline as it approaches a double bottom at 76, the next stops are 74 with a second support at 71:
[Click all to enlarge]
The yen (USDJPY) is also at a similar bottom, which ends at a spread double bottom at $80, which you'll have to zoom out to 1995 to see: