Fed Press Conference Deflationary Clues


Today Fed Chair Yellen gave a quarterly press conference about the economy. The key contrarian idea I got from the meeting was that Yellen said she feels the rate of decline of the Labor Force Participation Rate (which greatly helped to reduce the unemployment rate since the 2009 crash) will be bottoming out. This means that future reduction of joblessness will have to come mainly from actual job creation and not from a reduction of the people who seek to be in the work force.
If you believe that a reduction in unemployment causes inflation then this implies that significant inflation won’t be happening.

The mystery of the decline of the Labor Force Participation Rate has been attributed to people legitimately going on disability or on voluntarily going into early retirement. But why would the disability rate just happen to shoot up during the worst recession in 80 years? And why would people decide during this scary recession that they had suddenly become more prosperous and could thus afford to take early retirement! Ridiculous! What happened is some mediocre workers were forced out of work and could not find the moxie and toughness to get a job so they rationalized they were simply retired because it felt better to say that. Assuming they are overspending from their retirement portfolio then perhaps during the next stock crash they will realize they simply must get a job. If crashes come every seven years and it has been five years since the 2009 crash then in two years there may be a lot of angry stock investors ruined by a crash who will reenter the labor force, creating a drastic increase in the unemployment rate just as a new recession creates more layoffs. Assuming that bond markets are efficient then the bond market has anticipated this in the ten year forward “term premium” calculation and has thus priced in low rates into the current price of the ten year Treasury.

After Yellen’s conference today bond rates went down and were lower than three of the last four days. Thus the market is saying, despite her admission that she may be a little more tolerant of inflation as part of her goal to reduce unemployment, that inflation will be low and unemployment high for a long time.
Assuming the huge drop in the Labor Force Participation Rate during the past five years was mainly due to discouraged workers giving up on job hunting then the “real” unemployment rate should be roughly 3% higher. This extra 3% just happens to be the amount of extra jobs needed on a population adjusted basis to match the old peak employment of the 2007 boom year.

I used to be considerably unhappy that the Federal Reserve was using Quantitative Easing to increase the money supply to cause inflation and thus rob savers of purchasing power. However, after hearing Jeff Gundlach say he had done a study showing that QE only lowered bond yields by 0.5% and hearing others say that the marketplace may have discounted and ignored these QE manipulations, or that the QE was simply irrelevant, or hearing some even claim it was deflationary because it reduced the income of retirees then I changed my opinion. Instead of feeling that we are close to full employment so that the Fed needs to raise rates, I now feel that the labor market (for the bottom 80%) has not healed very well since the crash of 2009. This means that the low and declining interest rates of 2014 are not an aberration caused by foreign countries or speculators but are a legitimate phenomenon.

A benchmark concept is that bond investors are primarily logical, professional, non-emotional, institutional and thus far less likely to engage in a bubble. When confronted with a fork in the road between going with a bond expert’s opinion versus a stock expert’s opinion, the probability is great that the bond expert has the correct view. Stock experts may be bullied by public opinion to be a permabull so as to be popular. Public opinion may have pressured stock experts and journalists to become bubbly about stocks. But when have you ever heard of retail consumers becoming bubbly about low yielding Treasury bonds?

So the Invisible Hand of the market is trying to tell you something regarding low yields. The message is that nothing has been done to fix the Eurozone, Japan or China, all of which have less efficient ways of operating their economy and far more debt than the U.S. So if 80% of the U.S. people are not doing that well and other large regions have not fixed their problems then where will the global demand come from that will create growth and inflation? If global GDP growth is under 2% that may cause the economy to run below the “stall speed”, which may trigger a recession.

People leaped to the false conclusion in 2004 that if Greece and other peripheral Eurozone countries joined the Eurozone that this would make them more solvent borrowers. Instead they became a worse borrower. People incorrectly leapt to the conclusion in recent years that because the Fed and Treasury bailed out the TBTF institutions in the U.S. that somehow the crash was just a hypothetical phenomenon that had no real substance. But the crash was about realizing that “Alt A” mortgage borrowers with perfect credit ratings had incurred more debt than they could afford and that mortgages had been fraudulently rated and sold to banks. Now the problem is that society doesn’t realize that the reason for the great 2008-09 crash was real and not due to a panic and that such problems can’t be fixed simply by re-amortizing loans into smaller payments with lower interest rates.

Both the problems of the hidden discouraged unemployed and the financial problems of excess debt and low GDP growth have not really been solved. Excess debt acts to suppress demand. The combination of unsolved low growth, high debt, high unemployment implies that low inflation and low interest rates are legitimate and are far more correct and far easier to confirm as correct than today’s overpriced stock market.

Investors need independent financial advice about the risk of inflation and deflation damaging stocks and bonds. I wrote an article “Which is correct: stocks or bonds?”


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About the author

Don Martin, CFP®

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