John Butler

The US Bureau of Labor Statistics (BLS) recently reported that consumer price inflation (CPI) declined in September to a 59-year low of just 1.1% y/y. Excluding more volatile food and energy prices, the so-called core CPI rose only 0.8% y/y. This is not good news for the US Federal Reserve, which considers this a dangerously low rate of CPI. While the Fed lacks a formal CPI target–unlike many other central banks–it nevertheless seeks to keep inflation sufficiently above zero so that, should the economy weaken further, low inflation is unlikely to turn into outright deflation, something the Fed considers it necessary to avoid at all costs.

With a range of economic indicators now suggesting that the rate of US economic growth has moderated of late, the Fed is preparing to add additional monetary stimulus to the economy, most probably in the form of expanded US Treasury purchases. This, the Fed appears to believe, will lower borrowing costs and perhaps further weaken the dollar somewhat. That in turn should stimulate economic activity such that the risks of consumer price deflation diminish.

Now the Fed is not necessarily highly confident at this point that this is going to work. Indeed, there is an unusually large amount of dissent at the Fed at present. A number of senior Fed officials–most notably Thomas Hoenig, President of the Kansas City Fed–are skeptical that additional monetary stimulus will have the desired effect on the economy and, in fact, might be counterproductive.

Why might additional stimulus be ineffective? After all, the Fed has a long track record of injecting monetary stimulus into the economy from time to time, supporting growth and preventing deflation. Indeed, as observed above, there has been no consumer price deflation in the US for two full generations, and no severe, prolonged deflation since 1934.

Well there are signs that Fed stimulus to date is not having much effect. Notwithstanding near zero policy rates and a doubling of the monetary base, the economy is clearly struggling and CPI has continued to trend lower amidst spare capacity in many business sectors. With broad un- and underemployment currently at 17%, most US workers are not in a position to demand higher wages as firms seek ways to maintain profit margins amidst weak final demand. (Real final sales, which subtracts changes in inventories from GDP and thus is a more stable measure of economic activity, has grown at a mere 1% over the past two quarters.) The employment cost index (ECI), which measures the rate of growth of total compensation–wages and benefits–has risen a mere 1.8% over the past year, far below the 3-4% average of the past decade and barely above the 1.1% rate of CPI y/y. Until un- and under-employment declines substantially, additional money flooding into the financial system is unlikely to have much if any impact on wages and, hence, is unlikely to contribute, at least not directly, to a rise in CPI.

But what about growth? Won’t additional money creation stimulate business investment, eventually supporting the job market, wages and consumption, thereby pushing up CPI? Well that is certainly what the Fed would like to see, but with both business and consumer confidence extremely weak, it is far from clear that any additional money created will do anything other than push up banks’ so-called “excess reserves”, that is, money which the Fed has made available to the banks but which they have chosen not to lend out in some form.

Many refer to this sort of situation as a Keynesian “liquidity trap”. You can lead the horse to water (liquidity) but you can’t make it drink (borrow/invest/spend). Keynes’ solution to this problem was for fiscal policy to go where monetary cannot, which is to force additional spending, either indirectly, via a debt-financed tax cut or, directly, through increased government spending. The former can be considered “supply-side” and the latter “demand-side” forms of stimulus but from a broad macroeconomic perspective they amount to much the same thing: Both are, in effect, attempts to spend one’s way out of an economic downturn brought about by excessive debt and financial leverage. The effects of such policies might look nice on the aggregate income statement for a time–in that economic activity remains artificially elevated–but the aggregate balance sheet is going to deteriorate as a result. And as any good financial analyst knows: The income statement is the past. The balance sheet is the future.

A deteriorating balance sheet, or expectations thereof, normally would lead financial markets to demand a higher risk premium to hold a company’s stock, which implies a lower price-to-earnings (P/E) ratio. This can come about, however, either through a decline in the price of the stock, an increase in the earnings yield, or some combination thereof. In the event of sovereign balance sheet deterioration, however, as described above, there is no “stock” per se, but there is a yield on a government bond. If global investors observe a deteriorating sovereign “balance sheet”, they will demand a higher yield premium to hold that bond relative to some other asset. As the yield rises, the price of the bond declines, in effect devaluing the debt and reducing the “P/E ratio”. But then what happens when the central bank resists a rise (or facilitates a decline) in bond yields by lowering policy rates or buys up bonds directly in permanent open market operations (POMOs), as the Fed is now doing?

In this case, the required adjustment cannot fully take place via a higher bond yield, so instead, the price of the bond must decline in real rather than nominal terms. For this to happen, the currency must decline. It is no coincidence that, as the Fed has made it increasingly clear to financial markets that it is prepared, in principle, to expand the POMO program indefinitely until inflation (or expectations thereof) rises by a desired amount, the dollar has declined sharply versus nearly all other currencies.

Regards,

John Butler,
for The Daily Reckoning

[Editor’s Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]

John Butler

John Butler has 17 years experience in the global financial industry, including European and US investment banks in London, New York and Germany. Recently, he was Managing Director and Head of the Index Strategies Group at Deutsche Bank in London, responsible for development and marketing of proprietary, index-based quantitative strategies in global interest rate markets. Prior to DB, John was Managing Director and Head of European Interest Rate Strategy at Lehman Brothers in London, where his team was voted #1 by Institutional Investor. He has contributed to financial publications including the Financial Times, Wall Street Journal, Boersenzeitung and Handelsblatt.

Recent Articles

It’s Time to Buy Microcaps for Double-digit Gains

Greg Guenthner

Yup, small-caps are setting up for a comeback year. In fact, I believe they'll retake a leadership role in the markets in 2015. So now's your chance to set yourself up for potentially massive gains before these stocks start grabbing headlines again. Or... you can simply wait until some ex-purt on CNBC or Fox recommends them - and miss out on half the party. Your choice...


Can Money Printing Cause Deflation?

Marc Faber

"There has been an issue that has preoccupied my mind for a long time," writes Dr. Marc Faber. "In economics, it is generally accepted that if the quantity of money and credit is increased, prices will rise… However, since economics is so complex… I question whether the expansion of central banks' balance sheets and policies of zero interest rates could have a deflationary impact…" The good doctor wrestles with the question, in today's essay...


How Low Will Oil Go – And What Can You Do?

Matt Insley

The oil market has been under siege for six months. From service providers to producers this downturn has been painful. Of course, we’ve known all along that oil prices were a little toppy over the summer. In fact, when asked just how low oil prices could go I usually answered with a simple “lower than you’d expect…”


Cuba’s Berlin Wall Moment

Peter Coyne

Our forecast that Cuba would be open and integrated within 5-10 years is on track after yesterday's big announcement. Ahead of schedule, even. Click here to see how some investors have profited and what the island's likely future is...


The $4 LED Trend You Don’t Want to Miss

Chris Mayer

The opportunity to sell and install LEDs is enormous. We’re talking about over a billion lighting fixtures. And the areas with the largest potential -- like parking lots -- have barely begun to change. Banker to the presidents Chris Mayer says you could triple your money in this new tech trend. Here's what you need to know.


Forget the Oil Crash – Crush the Market With Biotech Stocks

Greg Guenthner

The Biotech iShares ETF is up 23% since the Oct. 15th bottom. No, that is not a typo. Biotechs have torched the S&P over the past two months--more than doubling the returns of the big index. And biotechs as a group are up more than 38% year-to-date. In fact, since we first highlighted the June comeback, the Biotech iShares have gone nowhere but up.


How to Make the Casinos Pay You for a Change

Greg Guenthner

It's a theme we've shared with you since April. And it's only gotten worse. The gaming industry has come under all sorts of pressure--a situation I first noticed in the charts. The powerful, multi-year uptrends started showing cracks. And it wasn't long before those cracks turned into gaping holes you could drive a friggin' truck through. That's where things stand today.