Wednesday, 22 September 2010

Fed as a dis-inflation fighter

Under normal circumstances I consider close reading of the Fed statements about as useful as Bible exegesis. Important for the believers, but an utter waste of time for everybody else. The early August statement was, however, right up my alley as Fed clearly gave the hyperinflationists a cold shower:  the ballooning of Fed’s balance sheet is not leading to any kind of inflationary pressures as long as the excess capacity in the US (you could substitute that by “OECD” if you like) is at the highest in decades.

This time, Fed is back at the same issue. But in a way that the FOMC is now risking to paint itself into a corner.

Firstly, Fed does not expect dis-inflation. Instead they expect inflation to hit a bottom at roughly zero: “The Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be modest in the near term”. We are talking price stability, not falling prices.

But the inflation is clearly too low: “Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability”.

And what will Fed do about it? Nothing, at least for now: “The Committee (...) is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate”

Let us recapitulate. Inflation is falling towards zero because growth is below par. As the output gap is not closing at a fast clip, deflationary forces remain strong. Over time, this gap will close, so inflation will come back to desired levels. And in the meantime, we will be ready to add liquidity to the economy in order to stave off disinflation.

But honestly, since households are still restrained by “tight credit” and businesses are investing but at a slower pace than last year, what is it exactly that the “additional accommodation” that may materialise should actually do.

We are still in a classical “liquidity trap”, the QE has saved the banking sector but has not materially contributed to the economic growth. And now Fed has promised us more in case dis-inflation continues.

I am afraid it is not enough. Deflationary pressures remain strong, and monetary policy will not contribute to closing the output gap, as long as we are in a liquidity trap. More demand is needed. Which Fed of course cannot control.

This is good news for bond holders. Not so for equity investors, but they seem to be blissfully insouciant of the underlying situation.

Price trends appear never to be able to make it to the headlines. Until it is too late, that is.

There is one investment conclusion possible: go short inflation protection.

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