It appears that the US is on the verge of outright deflation for the first time since the crash. The dollar price of everything is falling: oil, commodities, gold, silver, the euro, the yen, sterling, the peso. The PPI is falling. The CRB index is down 20% since June. Bond yields and expected inflation have been falling since June, and 5-year expected inflation is one-third below the Fed's 2% target. When the FOMC says that inflation expectations are "well anchored", they are speaking literally, as in: "There's an anchor tied to inflation expectations".
Since deflation is a monetary phenomenon, what is the monetary policy that explains it? In a nutshell: the Fed has been tightening money growth in the face of deflationary pressures. In gold standard terms, the Fed is raising the dollar's gold content and reducing the dollar price of gold, as it did after the Civil War and World War I. Money growth has been declining for over two years, the yield curve has been flattening since December, and the real funds rate has been rising as expected inflation has been falling. This called hitting the monetary brakes.
In my recent post ("Prepare For The Coming Economic Boom"), I wrote that "Falling commodity prices and zero headline inflation suggest that the risk of deflation remains. The control of the FOMC by the hawkish bloc means that the risk of a premature rate hike is very real."
In my judgement, the risk of outright deflation has risen in the past week, given the market data described above. I believe that falling commodity and producer prices will begin to appear in headline CPI and, ultimately, core CPI. Such deflationary forces would be compounded if the Fed went ahead with its plan to raise the nominal and real funds rate next year. Now, one might think that headline deflation might dissuade the Fed from raising the funds rate, but there is no compelling evidence to support such a sanguine view.
The hawks are clearly running the Fed while Chairman Yellen is traveling around giving speeches about income inequality. It appears that Yellen sees herself as the Left's ambassador to the Fed and vice-versa, but it is evident that she exerts little or no influence on policy. We may as well have Charles Plosser or Richard Fisher as chairman, for all the difference that Yellen has made. It was once said by critics (such as Professor Ben Bernanke) that the Fed was at risk of becoming Japanese. Now that Japan has a higher inflation rate than the US, the risk is that the Fed is becoming German. (Tim Duy has discussed this issue, and lays particular blame at the feet of vice-chairman Stanley Fischer, whom he sees as a hawk with more intellectual authority than his nominal superior.)
As is the case with the ECB, we don't know much about the internal political dynamics of the FOMC. We know who is hawkish and who is dovish, but we don't know how far the dove bloc is prepared to go in opposing the hawkish consensus. Will one of them (i.e., Mr. Kocherlakota) start giving more strident speeches? Will more of them dissent? One can only hope that, as deflation begins to appear in the Fed's targeted numbers, the doves will revolt. Until then, we will see the falling CRB and PPI begin to contaminate the CPI in a rather dramatic way, much as it has already affected expected inflation at all horizons.
Here is the text of Mr. Kocherlakota's most recent dissent:
Mr. Kocherlakota dissented because he believed that, in light of continued sluggishness in the inflation outlook and the recent slide in market-based measures of longer-term inflation expectations, the Committee should commit to maintaining the current target range for the federal funds rate at least until projected inflation one to two years ahead has returned to 2 percent and should continue the asset purchase program at its current pace. Mr. Kocherlakota noted that when the Committee first reduced its asset purchases in December 2013, it said in the post-meeting statement that it would be monitoring inflation developments carefully for evidence that inflation was moving back toward its objective over the medium term; Mr. Kocherlakota indicated he saw no such evidence.
We need a few more Kocherlakotas.
I stand by my earlier article about the economy's long-term favorable prospects. Monetary policy mistakes can be corrected, while the underlying dynamics (stronger credit growth, stabilizing velocity) remain undisturbed. I remain bullish on equities, since falling bond yields and falling price multiples make stocks less expensive (they raise the equity premium). The deflation problem is man-made and can easily be corrected by the Fed.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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