The Fed’s current monetary policy looks reckless only for those who see inflation bubbling. The same monetary policy looks prudent, even prophetic for those who see deflation as the dominant risk.
Our bias, for what it’s worth, leans toward inflation, as our posts over time suggest, such as this one. And we’re not alone. That doesn’t make us right, and to the extent that the crowd’s on board with this idea gives us pause. Nonetheless, from what we can tell, inflation risk looks to be the bigger threat, although that view is contingent on a future of a fairly orderly downturn in the business cycle followed by a somewhat routine recovery in a timely manner.
As for the belief that the crowd’s thinking inflation: one clue is found in the rush into inflation-linked Treasuries. The iShares Lehman TIPS, for example, posts a 12.9% total return for the year through last night’s close, according to Morningstar.com. That’s far above the 7.6% total return for nominal bonds overall during that span, as per the iShares Lehman Aggregate Bond. Another sign that inflation expectations have deep roots: the bull market in commodities prices. The iPath Dow Jones-AIG Commodity ETN, for instance, boasts a total return of more than 25% for the past year.
One can surmise that inflation fears have the market’s attention, but it would be wrong to say that alternative views are absent or even misplaced. Indeed, some believe that deflation risk is relatively high and rising. Leading this charge is the deflation master-in-chief: Fed Chairman Ben Bernanke.
It certainly helps seeing Bernanke’s aggressive easing strategy in a prudent light if deflation is a real danger in the foreseeable future. If so, dropping interest rates quickly and dramatically looks like a reasonable strategy for minimizing the potency of the approaching deflationary forces.
Then again, if inflation is the bigger threat, Bernanke’s current game plan looks rash if not irresponsible.
Alas, no one knows what’s coming and so we’re all–central bankers included–reduced to guessing, a.k.a. forecasting, predicting, etc. Some guesses are better than others, perhaps because some guesses are better informed than others. Still, in real time it’s hard to tell one from the other absent the passage of time.