Why the Fed is Steering the Economy Into Deflation

The Fed is steering the economy into deflation. It's a political calculation that will keep unemployment high, increase excess capacity, and deepen the recession. The Comsumer Price Index continues to fall, bank lending is down 4 per cent year-over-year, housing prices are slipping, business investment is off, and consumer credit continues to shrink. On Wednesday, the Commerce Dept reported that retail sales fell 0.5 percent, more than analysts expected. This is the second drop in retail purchases in the last two months, signaling weakness in consumer demand. The slowdown hit nearly every sector including auto sales, furniture, computers, building materials, clothing and sporting goods. There was also bad news on housing on Wednesday. The Mortgage Brokers' Association reported that loans purchase applications fell to a 13-year low last week, and refinancing contracts continued to slide despite record-low mortgage rates. The housing depression is ongoing and is adding to deflationary pressures in the broader economy.

Federal Reserve chairman Ben Bernanke claims the recovery is still "on track", but more than 60 per cent of last quarter's GDP can be attributed to fiscal stimulus and inventory adjustments. That means demand will drop as the stimulus runs out and restocking ends. Then the economy will have to stand on its own. Expect negative growth by the forth quarter 2010 or first quarter 2011.

There are things the Fed can do to fight deflation. Bernanke can resume his bond purchasing program (quantitative easing), this time buying US Treasuries to increase inflation expectations and add to the money supply. Or the Fed can purchase corporate bonds to increase business investment and hiring. Even a bit of jawboning would help; like issuing a statement saying that the "extended period" for zero rates will last for at least two years or more. That will assure businesses that their long-term plans will not disrupted by unforeseen rate hikes. Instead, the Fed chooses to do nothing.

Last week, Richmond Fed President Jeffrey Lacker summed up the Fed's position, saying that any consideration of further monetary easing "is very far away....It would take a very substantial, unanticipated adverse shock" for the Fed to resume its QE program. This appears to be the prevailing view at the Fed; wait-and-see while the economy tanks and the GOP takes congress in a landslide in November. The Fed is essentially a political institution.

Here's a thought from economist Bradford DeLong who warned early-on that the Obama stimulus was too small to sustain a recovery and reverse the output gap and soaring unemployment:

"The Federal Reserve has already increased the monetary base to a previously unimaginable extent and has doubled its balance sheet to $2 trillion. Even though there is good reason to think that further increases in the money stock alone will have little effect on the economy--that conventional monetary policy is tapped out--the Federal Reserve could always further increase its balance sheet to $3 trillion or $4 trillion. Such quantitative easing would be highly likely to eliminate fears of possible deflation or other lower tail risks and act as a powerful spur to investment. Such an enormous expansion of the balance sheet would produce a qualitative improvement in the assets held by the private sector, which would greatly reduce risk spreads and make funding available to American companies on much more attractive terms." ("A Keynesian voice crying in the wilderness", Bradford DeLong, Grasping Reality with Both Hands)

Bernanke has more arrows in his quiver, but he chooses not to use them.

The stock market is sending mixed signals, but volatility on low volume tells us nothing about the state of the so-called "recovery". It's just noise. Personal consumption expenditures and housing typically lead the way out of recession, and both are still showing little sign of improvement. Housing is headed for a double dip while personal spending is down. Consumers face a long period of deleveraging and retrenchment. Consumer demand will likely be weak for a decade or more without wage growth and a better jobs market, neither of which are forthcoming.

This is from the IMF's "World Economic Outlook" report:

"Inflation pressures are expected to remain subdued in advanced economies. The still-low levels of capacity utilization and well anchored inflation expectations should contain inflation pressures in advanced economies, where headline inflation is expected to remain around 1¼–1½ percent in 2010 and 2011. In a number of advanced economies, the risks of deflation remain pertinent in light of the relatively weak outlook for growth and the persistence of considerable economic slack."

Inflation is not a problem. The economy is in a depression. The historic low yields on Treasuries indicate an appetite for high-quality liquid assets. The Fed should satisfy that need by issuing more debt, selling more Treasuries, increasing inflation expectations. That would increase spending and pull the economy out of the doldrums. Instead, Bernanke preaches austerity, because the real objective is political--dismantling Social Security and other popular programs. Bernanke (a Republican) has aligned himself with the GOP and Wall Street who seek to bury Obama in the midterms by trashing the economy, keeping unemployment high, and increasing the prospect of another vicious downturn.

Meanwhile, deflation looms larger by the day. Here's a clip from a recent article by John H. Makin in the Wall Street Journal:

"U.S. year-over-year core inflation has dropped to 0.9 percent--its lowest level in forty-four years. The six-month annualized core consumer price index inflation level has dropped even closer to zero, at 0.4 percent. Europe's year-over-year core inflation rate has fallen to 0.8 percent--the lowest level ever reported in the series that began in 1991....As commodity prices slip, inflation will become deflation globally in short order....By later this year, persistent excess capacity will probably create actual deflation in the United States and Europe....

The G20's shift toward rapid, global fiscal consolidation--a halving of deficits by 2013--threatens a public sector, Keynesian "paradox of thrift" whereby because all governments are simultaneously tightening fiscal policy, growth is cut so much that revenues collapse and budget deficits actually rise. The underlying hope or expectation that easier money, a weaker currency, and higher exports can somehow compensate for the negative impact on growth from rapid, global fiscal consolidation cannot be realized everywhere at once. The combination of tighter fiscal policy, easy money, and a weaker currency, which can work for a small open economy, cannot work for the global economy." ("The Rising threat of deflation", John H. Makin, Wall Street Journal)

Obama intends to double exports within the next decade. Every other nation has the exact same plan. They'd rather weaken their own currencies and starve workers than raise salaries and fund government work programs. Class warfare takes precedent over productivity, a healthy economy or even national solvency. Contempt for workers is the religion of elites.

When wages increase, spending increases, too. But wages cannot increase without investment, so investment is key to the process. The problem is that businesses are hoarding because consumers are deleveraging and repairing their balance sheets. So sales are off and consumption levels do not warrant further expansion, additional machinery, employees or products. The economy is in a holding pattern. True, the markets have improved and stocks have bounced off the bottom. But the real economy cannot move without extra stimulus.

The deficit hawks, the Bluedogs, the inflationistas and the Fed have taken us to the brink. We now face a general decline in wages and prices and the real prospect of a downward spiral. Digging out will not be easy.