Banging the Reflation Drum

By: Michael Cale | Tue, Jun 10, 2003
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Federal Reserve Chairman Greenspan once again raised the specter of deflation in his public comments last week. Mr. Greenspan stated that inflation "was not something of significance for the Federal Reserve to be concerned about".1 As someone old enough to remember the interest rates of the late 70's and early 80's it seems bizarre for the Federal Reserve Chairman to utter those words. For the Fed Chairman to believe that statement is one thing, to utter it in public is another. If the Fed Chairman has any reason to lose sleep, it is the risk of deflation, not inflation.

Mr. Greenspan's comments also indicated that any future interest rate cuts would be act as "insurance against economic weakness".1 He went even further to suggest that there was very little risk to another interest rate cut. "The reason why you are hearing a good deal about the deflation issue is that we perceive that as a low probability ... but the cost of addressing it is very small indeed".1 The bond market reacted immediately, sending the yield on the 2-year Treasury Note down below the Fed's 1.25% funds rate.2 By the end of the week however, the yield had climbed back to 1.25%.

I disagree with the premise that there is little to no risk in another rate cut. Mr. Greenspan has only five 25 basis-point cuts remaining in his Federal Funds rate arsenal before reaching a very Japan-esque 0%. And only two 25 basis-point cuts until penetrating the psychologically significant 1% level. At some point between a 1.25% rate and a 0% rate, fear will set in. The fear that deflation has taken hold no matter what the Fed does in an attempt to stop it. Once this conclusion is realized, the Fed will have lost the battle of preventing deflation and will then begin the battle of defeating deflation that has already arrived.

Mr. Greenspan's comments last week were another event in the Fed's public relations campaign to prevent deflation. The Fed has been working diligently to convince the financial markets and the public that deflation will not take hold in the U.S. The Fed began a very blunt public relations (PR) campaign last November with Federal Governor Bernanke's speech "Deflation: Making sure 'it' doesn't happen here" last November.3 The statement from the Federal Open Market Committee last May 6, while not mentioning the word 'deflation' explicitly, made it very clear that the primary threat to the economy is deflation, and the Fed is determined to defeat that threat. Mr. Greenspan's congressional testimony on May 21 and his comments last week were continuing salvos in the PR campaign to convince America that deflation won't happen in the U.S.

The target of this PR campaign is inflation expectations. Part of the reason that Japan is having such difficulty is that the expectation of deflation has taken hold with the public. The price level has fallen, and the expectation is that it will fall further. So the incentive is to postpone purchases with the expectation that prices will decline. In the aggregate, this reduces demand and causes producers to lower prices in an effort to generate demand, thus fulfilling the expectation of lower future prices. This cycle is driven by the expectation of deflation. Mr. Greenspan knows that if this expectation of a lower price level becomes entrenched, it may be very difficult to exit the deflationary cycle. So the Fed seems to be determined to convince the public that it's going inflate the currency.

This particular type of deflation that exists in today's world may be beyond the scope of any single country's central bank, or its central banker. As international economies have grown more and more connected, they have also grown more synchronized with each other. They all seem to suffer from too little demand and too much supply - all at the same time. This global deflation has certainly proven to overpower the central bank of Japan over the last decade. Let us not forget that Japan has the 2nd largest economy in the world. In the U.S. it appears that deflation is knocking at the door, despite 12 interest rate cuts by the Fed. Will interest rate cut number 13 finally have the desired effect? Let us hope so.

I suspect this global deflation problem may be nearing an end, or perhaps the beginning of the end. The Asian economies have been weakened somewhat by the impact of SARS. The industrial production numbers in many Asian countries has dropped. Less production means less supply (or at least reduced growth in supply). April's industrial production either declined or showed slower growth in Singapore, Korea, and Japan. Regardless, the reduction in production should result in less supply and help ease deflationary pressures, at least temporarily. Deflation appears to be abating in China; and there are signs of inflation in Korea, Indonesia, and India.

The U.S. economy has been showing signs of improvement. The ISM index for manufacturing (May) shows a better-than-expected value of 49.4 with strength in new orders. Although still indicating contraction (below 50), the report provides support that the turnaround may continue into June. The non-manufacturing side of the ISM report showed an increase from 50.7 in April to 54.5 in May. So the services sector, which makes up roughly 80% of GDP, is growing, and showing signs of strength. The rise in the stock market is also indicating that the economic picture is improving; or it's at least not as bad as it appeared a few months ago. Mortgage refinancings have spiked again due to record low rates, which should add support to the U.S. consumer.

Against this backdrop of good (or at least less-bad) economic news, I will be more worried than encouraged if the Fed lowers rates after the June 24th meeting. Certainly there is some reserve level that the Fed would like to maintain so that a rate cut may be initiated due to unforeseen events. I would speculate at least 50 basis points at a minimum, and possibly as much as 100 basis points. With such a reserve, the Fed would be able to offer some economic stimulus in the case of an economic shock, such as an oil price spike, a major terrorist attack, recession, currency crisis, major debt default, etc. Assuming a reserve of 75 basis points leaves only two 25 basis point cuts remaining to ward off the deflation demon. My view is that the Fed is beating the reflation drum through its PR campaign in an effort to avoid cutting rates. If the Fed is successful in creating inflationary expectations, then they may be able to hold rates steady until deflationary risks subside.

Nevertheless, the Fed does appear to be laying the groundwork for another rate cut later this month. If for no other reason, for "insurance" as Mr. Greenspan put it. The President of the Dallas Fed Robert McTeer also advocated further economic stimulus in an effort to accelerate economic growth. If economic news is generally good (especially employment) between now and the Fed's meeting later this month and the Fed does cut rates, I will interpret that as a signal that even the economic improvement seen to date is not adequate to prevent deflation. The Fed should have a better picture of the economy's health than most investors. There are precious few interest rate cuts available while maintaining some sort of reserve for contingencies. The Fed won't use them unless they have to. Expect the drum banging to continue.

1. Greenspan Raises Issue of Rate Cut
2. Treasury Yields Hit Historic Low, Defy Fed to Follow
3. Deflation: Making sure "it" doesn't happen here - Governor Ben S. Bernanke Speech to National Economists Club, Washington, D.C.
4. Investors Still Expect Fed to Cut Rates
5. Fed's McTeer: US needs faster growth


Michael Cale

Author: Michael Cale

Michael Cale
Financial Methods Inc.

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