The Treasury market's inflation expectations have bounced higher since the end of August, reversing the summer downturn that was driven by worries that deflationary pressures were on the march. Given the precarious nature of the economic rebound, it's premature to declare the deflationary scare over. But the evidence is certainly looking stronger (or less discouraging) for arguing that the Federal Reserve is ahead of the curve these days rather than behind it.
Exhibit A is the yield spread between the nominal and inflation-indexed 10-year Treasuries, a proxy for the market's inflation outlook. It's imperfect and subject to error, of course, just like every other metric that's used to forecast the unknowable future. But as a measure of market sentiment, it's worth watching. As of yesterday, this spread was 1.95%, up from around 1.5% in late August, as the chart below shows. Is that the all-clear sign? No, but it's obviously a move in the right direction.
The bounce in the Treasury market's inflation forecast is strengthened by the fact that commodities prices have been rising lately too. As one example, consider the recent increase in the iPath Dow Jones-UBS Commodity ETN (DJP), a broad measure of futures prices for raw materials. Since the end of August, this exchange-traded fund is up more than 10%. No sign of deflation here.
Another sign that the crowd thinks that the risk of deflation has been retreating recently: higher stock prices. The S&P 500 has been climbing almost non-stop since early September, returning to levels previously reached in May. That's a significant rebound because May was the month when deflation worries emerged anew and prices started to tumble.
Another reason for downgrading deflation fears a notch: money supply is no longer contracting on an annual basis. Weekly readings of seasonally adjusted MZM money stock, for instance, rose slightly on a year-over-year basis for much of September. That's still close enough to zero to wonder what the future holds, but the outright contraction in the annual change from the summer is clearly history, at least for now.
In fact, the central bank is reportedly set to expand its war on deflationary anxiety by formally raising its target rate for inflation. As Bloomberg News reports today:
Federal Reserve policy makers may want Americans to expect inflation to accelerate in the future so they spend more of their money now.Clearly, expectations that the Fed can and will do more to stimulate the economy—despite the fact that nominal interest rates are virtually zero—has changed the sentiment lately. For the moment, the idea that the central bank is out of bullets at the zero bound is on the defensive. Is quantitative easing (QE), in all its various forms, a silver bullet? No, but it can help, and perhaps more than the critics acknowledge. Yet there's also a danger of assuming too much. Still, QE isn't chopped liver, or so recent market actions suggest. In any case, the Fed seems inclined to continue with QE for the near term, as implied in yesterday's release of the minutes for the Sep. 21 FOMC meeting. Reviewing last month's discussions among the monetary mavens inspires expectations that the Fed will announce a new semi-bold round of QE at the next FOMC meeting on Nov. 2-3.
Central bankers, seeking ways to boost flagging growth after lowering interest rates almost to zero and buying $1.7 trillion of securities, are weighing strategies for raising inflation expectations as well as expanding the balance sheet by purchasing Treasuries, according to minutes of the Fed’s Sept. 21 meeting released yesterday.
Some Fed officials are concerned that expectations of lower inflation will become self-fulfilling, damping demand by increasing borrowing costs in real terms, the minutes said. By encouraging Americans to believe prices will start rising at a faster pace, the Fed would reduce inflation-adjusted interest rates and stimulate the economy. Chairman Ben S. Bernanke said in 2003 that Japan could beat deflation by using a “publicly announced, gradually rising price-level target.”
“The Fed is on the verge of actively targeting a higher inflation rate,” said Dan Greenhaus, chief economic strategist at Miller Tabak & Co. in New York. U.S. stocks advanced, sending benchmark indexes to five-month highs, the dollar fell and gold declined for the first time in three days after the minutes were released.
The true test, of course, is whether the Fed's ability to move market sentiment, on the margins or otherwise, will translate into real change in the economy, i.e., enhance job creation. Given the normal lag in the employment picture, definitive answers are going to take time. Meanwhile, the connection between QE and the labor market is an open debate, and one that elicits a fair amount of skepticism, and rightly so. Attempting to fend off deflation with monetary policy is one thing; creating jobs with QE is another. But for the moment, there's a bit more optimism that Bernanke and company can at least make a change for the better on the margins. The Great Experiment rolls on.
As always, there are risks, however. There are no free lunches in monetary economics. Many strategists (and some Fed members) warn that elevating inflation expectations is a dangerous game if—if—the Fed loses control of the momentum. In a world awash in debt and deficits, higher inflation comes prepackaged with some obvious hazards down the road. But at the moment, the debt and deficits are still creating a bias toward deflation, or at least disinflation. Arguably, the only reason we don't have outright deflation is that the central bank has kept the beast at bay.
Rest assured, at some point the inflationary threat will return...eventually. In the long run, the main challenge is navigating the transition from fighting deflation to keeping a lid on higher inflation. But not yet. Soon, perhaps sooner than we think, but not yet. The real problem is that deciding when the deflation risk is truly dead is as much art as it is science, perhaps more of the former. Monetary policy has come a long way since the errors of the Great Depression, but subjectivity is still alive and kicking.
This post has been republished from James Picerno's blog, The Capital Spectator.