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Fed Deflation Concerns Trump Inflation Worries

Economics / Deflation Oct 13, 2010 - 03:22 AM GMT

By: Bob_Browne


Sluggish job data released in the United States last week will once again highlight the U.S. Federal Reserve’s primary policy concern: an economic retreat back into a recession followed by years of deflation. We have never been in the double-dip camp, but we have no doubt about the Fed’s priorities, and neither does the global investment community. The president of the Federal Reserve Bank of New York, William Dudley, made it clear that the near-term risk of deflation trumped any long-term concerns about inflation. In fact, the market is now reasonably assuming the Fed is once again committed to asset inflation as a way to re-energize the real economy. The result has been a scramble for risky assets, and “The Bernanke Put” is already joining the popular market lexicon.

The Fed now has a clear message: deflation risk is unacceptable while inflation risk is manageable. It may very well discover, however, that asset inflation is easier to achieve than real economic expansion. Converting banking reserves into net credit expansion in the economy while households and local and state governments are retrenching will not be easy. On top of that, the national political environment is decreasing the odds of further fiscal stimulus from the U.S. federal government. It is thus up to the central bank to fill the gap, and the Fed is not acting alone. The Bank of Japan was lulled out of its 20-year stupor last week and announced that it, too, likely would start buying not just government bonds but also perhaps other financial instruments such as exchange-traded funds. Other central banks in the developed world are no less committed to low interest rates. While the arguments continue among governments about the pros and cons of fiscal austerity versus fiscal stimulus, the one thing they all seem to agree on is that their own respective currency is too strong.

Once again we are left to discuss the unintended beneficiaries. For some time, we have felt that low interest rates and quantitative easing in the United States would disproportionately benefit those markets and assets which are tied to the United States through aligned monetary policy but which don’t need such support – emerging market equities – or would increasingly offer attractive incremental yields in a yield-starved world – high-yield bonds. The other unintended beneficiary is, of course, gold, which continues to offer global investors a comforting store of value in a world where certain political authorities believe no interest rate is too low and no currency is too weak.

I was recently reminded of the multi-millennium role of precious metals as a store of value and medium of exchange. Last week, I took my sons to the Oriental Institute at the University of Chicago. While my sons failed to recognize the power of one particular exhibit, I did not. There on display was a slinky-like band of silver bracelets from the Mesopotamian period dated around 3,000 B.C. Apparently, back in the day whenever someone needed to buy something, he or she would clip off the necessary length of silver for payment, have it weighed and in return would receive a bushel of wheat, a pig, olive oil or whatever. It must be increasingly comforting to investors today that their gold and silver will still be accepted as a valuable commodity another 5,000 years from now.

In the near term, though, let us focus on corporate earnings, for we are about to see whether or not the corporate sector will struggle to maintain its momentum. Given the already-remarkable high level of operating margins, investors will be sure to hone in on top-line growth. The bellwether of the financial sector, JP Morgan Chase & Co., reports tomorrow. It will set the tone for its sector and possibly the overall market. After the strong market returns of the past month, we should expect to see some profit-taking on anything other than stellar news from many corporations. Investors should not shrink from a normal retracement. It’s time to stay focused on long-term goals and long-term themes that will stand the test of time – just like those Mesopotamian silver bracelets.

Bob Browne,
Chief Investment Officer
Asha Bangalore is Vice President and Economist at The Northern Trust Company, Chicago. Prior to joining the bank in 1994, she was Consultant to savings and loan institutions and commercial banks at Financial & Economic Strategies Corporation, Chicago.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.

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