Looking at the closing prices of the indexes yesterday only, you'd have thought it to be a relatively tame session. However, there was an intense level of volatility with a morning surge, followed by a dramatic drop... leading to a V shaped bounce in the afternoon before a closing minutes fade. It appears much of this was in reaction to Federal Reserve President (St Louis) James Bullard's comments on the potential for deflation to hit the U.S. Those wondering why the 10 year bond is struggling to keep its head above a 3% rate can point to one of two things (or both) - the next leg of the Great Recession, or future deflation.
These comments and the discussion on how to combat it - another round of quantitative easing - are being couched by the mainstream media as 1 rogue member talking a bit out of turn. But generally in the Bernanke Fed (unlike the monarchy of the Greenspan Fed), specific members lay the groundwork well ahead of time (sort of like scouts) for the greater body. While I don't think deflation is being taken completely seriously, I do think QE 2.0 is. We saw another such leak to the Wall Street Journal about 3-4 weeks ago... I would not be surprised to see the next leg of desperation post election i.e. first half 2011.
I have come to the view the past 12-18 months, that deflation (or at least disinflation) is going to be near impossible to avoid (and in fact necessary) as the dichotomy between flattening wages (in the private sector) and government policy to support out of whack inflation in certain sectors (healthcare, university education) is causing an inability to spend ability in other sectors. This is currently being hidden to a degree by massive fiscal stimulus, including 1 in 5.5 of every dollar of income in America now being a transfer payment from federal government. Not to mention a large swathe of the population living in homes they are not making payments on for 18, 24, 30 months. Without a new housing bubble created (to allow house ATMs to become widespread) a bout of deflation seems more and more likely by the day, at least in sectors the government is not subsidizing - and ironically making the situation worse, when they think they are 'helping'.
Time to get the We're Not Japan pom poms out.
- Debate is intensifying at the Federal Reserve over how best to cope with a weakening recovery, with momentum growing for a concrete plan to prevent a backslide into recession. That came into view Thursday as James Bullard, president of the Federal Reserve Bank of St. Louis, offered a specific proposal. He said the Fed should revive a crisis-era program to buy government debt if the country seems headed toward a bout with deflation.
- Fed Chairman Ben Bernanke has yet to endorse precise steps, only saying that the Fed is ready to act if needed. He has mentioned possibilities, while committing to none.
- Bullard, a voting member this year on the Fed's main policy-setting committee, worries that the United States could tip into a Japanese-like bout of deflation if the economy weakens. Deflation is a widespread and prolonged drop in prices of goods, values of homes and stocks, and in wages.
- For now, Bullard thinks the deflation risk is still low. But the danger could grow.
- Bernanke told lawmakers on Capitol Hill last week that the Fed policymakers had several options if the economy worsens. They could cut to zero the interest rate paid to banks on money parked at the Fed. They could also provide more information about how long it will keep interest rates at record lows. And the Fed chief left the door open to relaunching programs to buy mortgage securities or government debt, the latter which Bullard says should be considered.
- Last year, the Fed bought up to $300 billion worth of Treasury securities. It marked an unconventional move to pull the country out of its worst recession since the 1930s. At that time, the initiative sparked controversy from critics on Capitol Hill and elsewhere that the Fed was basically printing money to pay for rising budget deficits and debt.
- In a paper released Thursday, Bullard also argued that the Fed's pledge to hold rates at record lows for an extended period is a double-edged sword. The pledge could make investors, businesses and ordinary people think inflation could be heading lower, which could aggravate the risk of deflation.
Video of Bullard explaining his thoughts on CNBC this morning [13 minutes] - email readers will need to come to site to view this: