Before I go further, let me note that we do not think we're entering a deflationary period that will at all resemble the Great Depression era. In 1932, US consumer prices fell 10%, and between 1929 and 1933, they fell a whopping 27% overall. The bigger risk (albeit still small in our opinion) is that we encroach on a Japanese scenario. Consumer prices in Japan have been falling for more than 15 years, but never more than 2% a year.
Double-dip recession fears subsiding
I think deflation fears will begin to subside as double-dip recession fears also subside. The latest readings on the economy were largely better than expectations, with some good news even found in the latest gross domestic product (GDP) report for the second quarter.
Although revisions showed that the recession was deeper than originally thought, the income and savings numbers were both revised higher. Given low inflation, consumers can manage to maintain their consumption and use the inflation-adjusted difference to increase their savings rate, which includes much-needed debt reduction.
In addition, this week's readings on US manufacturing and construction spending were also ahead of expectations, while initial unemployment claims have restarted their descent after a flat period that had some negative census-related biases.
When Fed heads speak ā¦
Deflation fears were stoked recently when James Bullard, the president of the Federal Reserve Bank of St. Louis, warned that the Fed's current policies were putting the US economy at risk of becoming "enmeshed in a Japanese-style deflationary outcome within the next several years." For those of you who are inflation hawks, you can no longer count Bullard in your camp.
Bullard appears to have joined the ranks of three other influential regional Fed heads: Eric Rosengren of Boston, Janet Yellen of San Francisco (nominated by President Obama to be vice chair of the Fed) and William Dudley of New York. All three are sympathetic to the view that the damage from long-term unemployment and the threat of deflation are among the greatest challenges facing the economy.
But two additional Fed heads probably said it best (OK, I say that because their comments support our case). Charles Plosser, president of the Philadelphia Fed said recently in an interview: "I think the fear of deflation in and of itself is probably overblown." He said that inflation expectations were "well-anchored" and noted that $1 trillion in bank reserves was sitting at the Fed. "It's hard to imagine with that much money sitting around you would have a prolonged period of deflation."
Richard Fisher, president of the Dallas Fed also said in a recent interview: "Reasonable people can argue that there's a risk of deflation, but we haven't seen it in the numbers yet."
Weak money multiplier = low inflation risk
The bottom line is that the Fed has pumped $2 trillion into the financial system via its purchases of government debt and mortgage bonds, while lowering interest rates to the floor.
To make those purchases, the Fed essentially printed money (the $1 trillion in reserves). Ifāand it's a big ifāthose reserves were lent out quickly, the money supply would increase rapidly and generate inflation. But as we've noted incessantly, bank lending has continued to contract and the velocity of money (or the money multiplier) remains extremely low.
As Rosengren of the Boston Fed notes, "ā¦ The creation of reserves, in and of themselves, isn't going to become inflationary and shouldn't affect inflation expectations, unless you see a banking system that is growing rapidly and starting to increase lending." Lending remains key to watch to see if deflation risk (now) becomes inflation risk (later)āa view that many share.
I will be on vacation next week when the Fed meets (Brad Sorensen will write our Fed commentary in my stead); but a top agenda item is likely to be whether the Fed should consider more new and untested actions to support the economy. The "extended period" phrase attached to the Fed's 0% interest rate policy is unlikely to change, but we will be looking for other more subtle indications of the Fed's plans.
