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The Lure of the Normal, Deflation and U.S. Monetary Policy

Posted by Joseph Trevisani on Dec 19, 2014 5:00:00 PM

The Federal Reserve has been hinting at a 2015 rate hike since Ms Yellen’s first official news conference.' Six months’ after the end of quantitative easing was the Fed Chair's incautious suggestion in March.  Ms Yellen used the mirror image of that formulation on Wednesday when she said that the Fed was unlikely to start a rate cycle for “at least the next couple of meetings.”

It is clear the Fed would like to start a cautious rate cycle mid-year. But markets should be wary of prematurely translating the Fed’s desire into action. 

The Fed governors chose to retain “considerable time’ for the duration of low interest rates in their statement and added the anodyne phrase, “The committee judges that it can be patient in beginning to normalize the stance of monetary policy. 

The FOMC could not remove ‘considerable time’, whose retention had been the focus of so much commentary, without markets assuming an earlier rate hike and exciting a surge in interest rates. As it was the 10-year Treasury yield gained 15 basis points from Wednesday’s open to Thursday’s close. So ‘considerable time’ was kept but demoted, and “patient”, a word with many meanings--ask any parent--is now the operational term for the monetary policy of the world’s most important central bank.

Rhetoric aside, the FOMC statement and Ms Yellen's answers in her press conference changed nothing. The Fed is now no more or less likely to raise rates at mid-year than it was before the FOMC meeting.  The basic standard remains. “The Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation.”

The American labor market is performing well. Ten straight months of 200,000 or more new jobs and a 5.8 percent unemployment rate have given the economy its best employment run in over 15 years. But inflation remains stubbornly below the Fed’s goal of 2 percent and the prognosis is not promising.

American consumer prices dropped 0.3 percent in November the largest monthly decline in seven years and are just 1.3 percent higher on the year. Sliding energy prices played a large part, but even the Fed’s chosen measure, the core PCE rate, was just 0.1 higher in October and up 1.6 percent on the year. These rates are forecast to drop to -0.1 percent and 1.5 percent in November.  The annual core PCE rate has not been at 2 percent since April 2012.

The dismissal of disinflation as a transitory phenomenon by Ms Yellen and others should not be taken seriously. Inflation and the potential for deflation, here and around the world, are about to replace unemployment as the Fed’s primary concern.

If the Fed governors are going to vote an interest rate increase for the first time in more than eight years they will have to be satisfied that it will not exacerbate the worldwide tilt toward falling prices.

The FOMC will have to assess the effect of the global economic slowdown, the collapse in energy costs and the deflationary impact of monetary policies in the European Monetary Union (EMU) and Japan on consumer prices in the United States before they act to increase rates in the United States.

Disinflation in the EMU is threatening to become deflation. Annual consumer inflation in the euro zone was 0.3 percent in November, a record non-recessionary low. The rate has been falling for more than three years. The last time inflation was at the ECB’s 2 percent target was January 2013.

In Japan the twenty year annual inflation average is 0.1 percent. Though Prime Minister Abe’s devaluation of the Japanese Yen has raised annual inflation from -0.9 in March of last year to 3.6 percent in May, presenting skyrocketing costs to the Japanese consumer, it had already subsided to 2.9 percent in October and is forecast to fall to 2.5 percent in November.

However, for the Federal Reserve’s inflation target the immediate problems are the monetary policies of the EMU and Japan and the soaring dollar.

A strong Yen and a weak U.S. Dollar imported deflation into Japan in run up to the financial crisis. So today a stronger dollar, and more importantly the deliberately weakened currencies of Japan, Europe, and perhaps soon China, may import deflation pressures into the Unites States. A U.S. rate increase will only enhance the dollar’s ascendancy.

Since May the Euro has lost more than 12 percent versus the U.S. currency. The Japanese Yen has fallen that much in just the past two months and is down a remarkable 46 percent in two years.

Emerging market currencies, even apart from the Russian Ruble’s 45 percent plunge in the past two months, have followed the yen and euro down adding deflationary impetus to global trade prices.

The Korean Won has lost nine percent versus the dollar since August to Friday’s close, the Indian Rupee five percent, the Indonesian Rupiah nine percent and the Mexican Peso 12 percent. The Chinese Yuan has reversed its four year rise to shed three percent against the dollar since the beginning of the year, 1.8 percent in the last seven weeks. Overall the U.S. Dollar index is up ten percent since August.

An official U.S. rate increase, or a market based rise like the so called ‘taper tantrum’ of last summer when the 10-year Treasury yield zoomed from 1.63 percent in early May to 2.99 percent in September could bring a host of negative effects. 

How would higher U.S. rates affect the parlous state of the world economy and by degree the U.S.? What would be its impact on arguably overvalued equity markets and consumer sentiment, consumer spending and on already plummeting commodity prices?  How much will a stronger dollar add to disinflationary pressures in the U.S.?  

The Fed's criteria for normalizing interest rates: a strengthening U.S. economy and labor market, incipient inflation, and perhaps a desire to curtail investment choices made necessary by low interest rates, do not, except for the last require action now or most probably on a six month horizon. In particular, the Fed’s repeated assertion that inflation will rise in 2015 and beyond is questionable.

The central bank’s record of inflation prediction is not especially good. Fed economists overestimated core PCE inflation by about 15 percent in 2013 and the same so far this year. The latest forecast for 2015 is for a central tendency of 1.5 to 1.8 percent for the core rate and 1 to 1.6 percent for the overall PCE rate.  If the same 15 percent over prediction holds for next year, then the actual core PCE could be 1.3 to 1.5 percent and the overall rate could be 0.85 to 1.36 percent.

Ms Yellen has said that the bank expects inflation in six months to be about where it is now.  Core PCE was 1.6 percent annually in October and is expected to be 1.5 percent in November. Would a core rate of 1.3 to 1.5 percent or perhaps lower given the burgeoning deflationary pressures in the world economy, be enough to change the Fed’s timetable?

As the Fed likes to say rate decisions are data dependent.  The logic for hiking rates mid-year and for telegraphing that intention to the markets soon, must be set against the real possibility that the need for higher U.S. rates will be much less come June.

The case for caution is simple if varied. The world economy could be worse at mid-year. Russian uncertainties, sovereign defaults, developments in Greece or elsewhere and their impact on the global financial system might require central bank attention. Global inflation could ebb further. The ECB and the Bank of Japan may well drive their currencies lower against the dollar. The American consumer on whom once again, so much hope is placed, and whose wages are set in a global deflationary environment, might decide that short of a substantial paycheck increase, spending and adding debt to the household  budget is a bad idea

Anyone of these of those realities would make a rate hike in the U.S. not just problematical but potentially damaging.

The Federal Reserve has consistently chosen prudence in the wind-down of its quantitative easing policies and exhibited an extreme sensitivity to rapidly rising interest rates. It is not about to change plan.  A June rate hike is far from secure.

Joseph Trevisani

Chief Market Strategist

WorldWideMarkets Online Trading

Chart: Bloomberg

Inflation: U.S-white; Japan-yellow; EMU-green; China-purple

worldwide inflation dec 17


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