The Fed's Opponent: Deflation (Michelle Gibley)

If the Fed lowers its growth outlook, it will likely need to lower its 2011 inflation forecast of 1.1-1.6%, leaving rates well below the 2% level the Fed believes is consistent with price stability.

A slow growth rate is seen as dangerousā€”the so-called "stall speed," similar to the concept for airplanes. The longer growth is below potential, the harder it is for growth to be self-reinforcing, and the higher the chance for deflation, or falling prices, to take hold.

Holding the size of the labor force and productivity static, economic growth needs to be above potential for the unemployment rate to decline. Meanwhile, second-quarter GDP growth in the United States was 1.6%, below the Fed's estimate of 2.75% potential growth.

Another negative aspect of deflation is the impact on debtors, because debt remains unchanged while asset prices decline, which can lead to forced sales and further reduce growth, as experienced in the housing market bust. When asset prices fall, it is difficult to get out of debt.

One way to fight debt-deflation is to promote rising asset prices, or reflation. By keeping short-term rates low, investors are incented to borrow at low rates and invest in riskier assets, increasing asset values and giving people the ability to reduce debt.

Lastly, growth is threatenedĀ with a deflationary spiral, where consumers postpone purchases because they expect lower prices in the future, thereby forcing companies to cut prices to try to spur demand. Lack of demand makes companies reluctant to hire, and this puts further strain on consumer spending.

Fed Chairman Ben Bernanke believes that in Japan, the lag in lowering interest rates allowed "deflationary expectations" to become entrenched and led to suppressed growth.

St. Louis Fed President James Bullard made recent headlines by saying that more QE may be needed in the event of another economic shock, stating "The US is closer to a Japanese-style outcome today than at any time in recent history."

The Fed has committed to doing whatever it takes, and appears to be more concerned about downside risks to growth.

Although it's not in the Fed's forecast, it's possible that the specter of deflation is viewed as a more negative outcome. This is because the Fed's policy tools are more effective in fighting inflation, and deflation is tougher to tackle.

Another potential outcome of more QE is that it could weaken the US dollar, boosting the competitiveness of US exports.

Avoiding a double-dip recession

While we acknowledge theĀ downside risks, we continue to believe the US economy will avoid a double-dip recession. Historically, a downward-sloping yield curve is the best recession predictor, and for now it continues to slope upward.

Export demand will likely continue to benefit from emerging-market economies, and capital spending could kick inĀ given thatĀ businesses have dramatically underinvested in recent years. Job growth could reaccelerate as corporate productivity falls: Businesses may have reached the limits of what their current workforces can produce.

While private sector payroll growth of 763,000 during the past eight months has disappointed, the household survey within the labor report, which includes small businesses and contractors, tells a different story, growing by 2.3 million jobs during the same timeframe.

Meanwhile, with interest rates already at historically low levels, we don't believe lowering the rate to borrow money, the cost of capital, is likely to spur economic growth and employment. Further, rhetoric out of Washington has done little to lower the cost of labor or engender confidence among business leaders.

We believe we're past the emergency stage of the economy and appreciate the benefits of free market principles. As such, we don't think that more QE is the silver bulletĀ for economic growth. Instead, we prefer actions that give businesses increased certainty about how to plan for future operating costs in relation to demand growth.

The next FOMC announcementĀ is November 3.

Important Disclosures
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative (or "informational") purposes only and not intended to be reflective of results you can expect to achieve.

Copyright (c) Charles Schwab & Company

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