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.
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 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.
Pingback: A Do-It-Yourself CREDIT REPAIR Kit that actually WORKS and is EASY to use
Pingback: car detailing floreat
Pingback: pop over here
Pingback: Toys Christmas 2013
Pingback: Watch on YouTube
Pingback: The Art of Weight Loss over Night
Pingback: Buy Rings, Buy Bracelets, Buy Necklace, Buy Jewelry, Buy gold
Pingback: how do you contest a will in the uk?
Pingback: Forex Strategy Master, Forex Strategy Master discount, Forex Strategy Master review, Forex Strategy Master bonus
Pingback: read more
Pingback: fg xpress
Pingback: Canon EOS,Unboxing and Review Canon EOS DSLR 60D Camera,EOS 60D Greatness
Pingback: Asbury Park NJ
Pingback: Please Rape Me!
Pingback: Social bookmarking
Pingback: la bourse pour les nuls
Pingback: SEO Services Outsourcing
The dollar in your pocket is worth a whole lot less today than 100 years ago. And you have the Federal Reserve to thank for you. So, as the Fed approaches its 100th birthday, Gregory Bresiger reflects on the controversial institution, relaying the criticisms of several of the Fed's most vocal opponents. Read on...
There's been a lot of press lately about the 3-D printing revolution - much of it right here on The Daily Reckoning. But there is one technology that's already threatening to make 3-D printing yesterday's news. Josh Grasmick examines a new kind of printing... that takes place in the 4th dimension. Read on...
Rejoice! What was perhaps the freest market in the entire world is now ended. Crushed. Wiped out by the swift hand of the state. Wait... That's NOT a good thing? (Sigh)... Oh well. It was fun while it lasted. Dominic Frisby explains why the shutdown of the Silk Road is such a travesty. Read on...
There is one chart, just one chart, that market analysts and gold bugs alike could learn a lot from. It displays clearly the ebb and flow of one critically important trend, where it's headed through the end of the year, and how you can use it to your advantage. Greg Guenthner explains...
China's push towards a more market-based economy could kick into high-gear, as recently proposed economic reforms are some of the country's most radical policy changes in over three decades. But what will that mean for foreign investors and how could it shape the global economy? Frank Holmes takes a closer look...
John Mauldin spoke with Steve Forbes on the future of gold and the Federal Reserve in an interview released yesterday. What he said may surprise you.