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The lack of inflation should keep the Fed on hold

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Even for long-time observers, it is sometimes remarkable how quickly market sentiment can change. Not too long ago, most everyone was concerned that the stock market rally could come to an end whenever the United States' Federal Reserve decided to raise rates. While the Fed had been giving strong hints that it would do so in September, in the end it kept rates unchanged around zero, pointing at weak global conditions among the reasons for doing so. Because those conditions are expected to remain in place for a while, this week the Financial Times asks: “What if rates never rise?”

“Never” is rarely the appropriate word to describe anything regarding markets. But that this question is now asked goes to show how much things can change in a short period of time. And it is not just the Financial Times who changed its mind: Fed Funds futures have moved steadily in that direction. This means that market participants do not expect the Fed to hike rates anytime soon. Just a year ago, the consensus was that Fed Funds would be at 1.5% in September 2016; today, the expectation is that Fed Funds will be at 0.5% at that time; in other words, barely higher than today.

US Financial Sector Debt vs. Federal Debt.

Perhaps a more important reason for the Fed to refrain from hiking rates is that inflation remains stubbornly low. Talk about deflation is back on the table, and this is a powerful deterrent to changing the current zero interest-rate policy (or "ZIRP").

The latest readings on inflation at the producer price level are negative. "Core” measures of inflation that strip out both commodity groups still register way below the 2% level that is considered desirable.

Unlike producer prices, "core" consumer prices have not fallen quite as much. But it is worth pointing out that the main item keeping core consumer inflation stable at 1.9% per year is rent. Taking out food, energy and shelter, inflation is up just 1% in the last 12 months. And the favorite inflation gauge of the Fed - the price index of personal consumption expenditures - also shows a steady decline.

US Financial Sector Debt vs. Federal Debt.

US Financial Sector Debt vs. Federal Debt.

US Financial Sector Debt vs. Federal Debt.

The inability of the Fed to push inflation up is worrisome, especially in the context of global conditions that could bring it lower still. To see why, consider the experience of Japan.

In 2004, Fred Mishkin, a highly respected economist who was on the Board of Governors at the Fed, wrote this about Japan’s deflationary problem:

"The [Japanese] uncollateralized call rate (the policy interest rate that corresponds to the Federal Funds rate of the United States) was lowered to virtually zero in February-March 1999. The Bank of Japan raised the call rate to 0.25% in August 2000 in false expectation of continuing economic expansion, against protests from the government and many economists [...] By 2002, the economy and the financial institutions weakened again. Deflationary expectations were setting in, and consumption and investment were depressed. Aggregate demand fell short of potential output, and the widened output gap depressed prices, reinforcing deflationary expectations. There did not seem to be a solution to the deflationary spiral [...] Given that deflation was not over at the time of ZIRP [Zero Interest Rate Policy] termination and that the ZIRP had to be re-instated, the interest rate hike of August 2000 was clearly a mistake." ("Two Decades Of Japanese Monetary Policy And The Deflation Problem", Takatoshi Ito and Frederic S. Mishkin, October 2004).

This can be easily applied to the United States today. Interest rates are at zero, and many analysts think they should remain at that level as long as inflation remains far below targets. If the Fed were to end its ZIRP prematurely, it may well have to reverse course in a not-too-distant future..

A mistake on this front could have severe consequences, since a premature rate hike could make deflationary pressures worse. Japan found out the hard way in the early 2000s: the untimely hike condemned it to a long era of falling prices and weak economic performance that still haunts it today.

Under that light, the Fed’s reluctance to raise rates was not only appropriate but inevitable, and unlikely to change for many months. If, however, it chooses to tighten monetary policy despite non-existent inflation, it will be making a huge gamble that offers a low payoff and carries considerable downside risk. The potential negative effects of a rate hike have grown in the last few months.

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