Deflation concerns at the Fed

In their release after meeting on Tuesday, August 10, the Federal Reserve Open Market Committee (FOMC) indicated they would now begin to purchase long-term Treasury bonds with the maturity proceeds of the approximately $1.3 trillion of mortgage-backed securities the Fed purchased during the 2008-2009 credit crisis.  Prior to this FOMC decision, the Fed plan was to let the mortgage-backed securities just roll off as they matured and gradually remove that stimulus.  The Fed made clear their concerns in their published statement after the meeting with language of "the pace of recovery in output and employment has slowed in recent months".

The fear now seems to be the possibility of Japanese-style deflation, with the U.S. 10-year Treasury now yielding 2.8% as compared to a 2010 rate peak of about 4% in April.  Note that even at 2.8% U.S. rates are 1.7% above comparable government securities in Japan, so there is still far to travel to reach those levels.  Further, in Japan the average monthly inflation since end of 1992 has been minus 0.1%, while in the U.S. the June 2010 data showed annual core CPI (excluding food and energy) of 1%, so we still aren't seeing U.S. deflation.

It is comforting to some that the Fed is tuned into slowing growth and deflation risks.  Others see the Fed as ineffective as they can't force monetary stimulus into a banking system where credit standards have tightened and loan demand declined.  Still others see the Fed actions to fight possible deflation in the short-term as leading to U.S. dollar currency devaluation and inflation in the long-term.  No one can clearly see where this is all going and investors have to be careful not to be whipsawed as the markets react to the latest news and government policy actions.

Deflation or inflation: Which poses the greatest risk?

The U.S. Federal Open Market Committee meets next week to discuss policy and they will likely be debating the question posed in this blog headline.  The potential of a policy mistake would seem to be rising.  Tighten too soon and the Fed could push the U.S. towards another dip into recession.  Wait too long (or be too loose with stimulus) and the seeds for future inflation could be sown broadly and deeply.

Many experts have said that while there is no concern about inflation in the next year or two, they expect the Fed to err in the direction of avoiding deflation, raising the prospect of higher inflation in the long term.  This makes good sense to us, but time will tell.

The important thing to recognize is that the chances of a policy mistake and the ultimate effects of such a mistake on both the economy and the markets are on the rise.

A halting recovery, but recovery nonetheless

Last week the U.S. government released numbers showing the economy grew at an annualized rate of 2.4% in the quarter ending June 30, 2010.  Compare this to a growth rate of 3.7% in the first three months of 2010 and 5% in the last quarter of 2009.

One can see a slowing of growth as businesses have achieved their desired level of inventory after allowing stocks of goods to decline significantly during the uncertainty of the credit crisis in fall of 2008 and first one-half of 2009.  Unemployment continues at high levels and weighs on consumer confidence.  Deleveraging by governments and individuals also is expected to hold the consumer back for some time.

Still,  the economic recovery continues in the U.S.  Stock investors seem to have become at least less pessimistic about the recovery and pushed stock prices up about 7% in July.  Things can always change, but those who were exiting stocks in May and June amid worries of a double dip back into recession seem to have missed the recovery story and the stock gains that accompany recovery.