The Fed Can’t Reach Inflation Target 85% Of The Past 19 Years

The Federal Reserve’s favorite inflation gauge, the PCE, has only gotten above the Fed’s target of 2% for three full years in 2005, 2006, and 2007 in the past 19 years. The years 2005-07 were when China imported an enormous amount of commodities far in excess of what would be used on a sustainable basis. That probably caused inflation to exceed the 2% target during those years. I guess one could joke that the Fed is so incompetent that they can’t even create inflation despite an enormous increase in the money supply from $4Trillion of Quantitative Easing. Thus, had there been no irrational China construction boom in 2005-2007, then the PCE would have never in 19 years have been above 2% for a full year. PCE was up 0.3% in a year most recently.

Interestingly enough the Atlanta Fed forecasts only a 0.3% first quarter GDP. An old rule of thumb is that the ten year Treasury yield should be the sum of GDP and inflation, if this is so then the ten year Treasury should yield 0.6% instead of the current 1.95%. Germany’s yields 0.18%. In Japan people kept short selling the Japan Treasury bond and yet the price got higher (yield dropped). Will the same thing happen here?

Since there are few retail bond bulls and institutional bond investors are very cautious then the bond market takes on the gravitas of a wise behavior of an efficient market discounting the probability of a future recession. If QE and traditional Keynesian deficit stimulus are eventually proven to be of no use and are abandoned then the next solution might be debt haircuts which would motivate creditors to flee into the safety of sovereign debt. This explains why yields are low.

Investors in risk-on assets such as stocks, commodities, and real estate should respect the warnings of the Invisible Hand of the market and consider reducing their holdings of risk-on assets even if it means earning not much of anything in bonds.

The failure to rekindle inflation means that those burdened with debt will have a harder time growing out of it and thus the economy will be stuck in secular stagnation. This means interest rates will remain low for a long time, far longer than people would consider to be a reasonable time. The problem with debt is that some borrowers will experience variability of income and earn less than is needed to service the debt and in a deflationary economy they will be much more vulnerable to going into default. For example a 2% inflation rate means in 5 years the borrower, instead of paying 40% of income for debt service would pay 30%. If no inflation then he’s trapped at 40% and if a 10% pay cut occurs during a time of no inflation then the borrower would pay 45% of income for debt service. Inflation plays a vital role in solving the problems of debtors and encouraging new borrowers to take the plunge and get into debt in order to buy an asset. In a way the system of debt is almost an accidental Ponzi scheme since new borrowers are lured by hopes of inflating away their debts. Without inflation the debt mountain suddenly becomes very steep and icy and is too hard to safely climb.

An increase in disinflation increases risk to a borrower which lowers the Sharpe ratio for his debt fueled project. Collectively speaking society becomes poorer as the debt financed assets owned by society experience greater risk and lower risk-adjusted returns, ultimately resulting in a repricing of risk assets so as to boost the Equity Risk Premium. And how does the “repricing” occur? It happens when overburdened borrowers give up and sell and the price of risk-on assets like stocks go down low enough so that the new buyers can get a decent return.

The Invisible Hand knows this and is working to reprice bonds to get ready for this. Stocks don’t know this because their pricing has been hijacked by irrational retail investors. Eventually the truth will come out when loan default rates climb then stocks will go down. Investors need independent financial advice about the risks of a global deflationary situation. I wrote an article “Is deflation a harmless prank?

 

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Don Martin

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