The week ahead will surely be a stress test. Friday’s downgrade of the U.S. credit rating, although hardly a surprise, seems to have unleashed a higher round of risk aversion in world markets. Equity prices are tumbling around the globe, and early indicators suggest that no less is in store for stocks in the U.S. today. What’s the economic logic behind the selling? The main worry is deflation. Yes, it looked like that problem was solved. Many analysts have continued to scream that inflation was the main challenge ahead. But the one-two punch of deleveraging and slow growth that has plagued the U.S. and mature economies never really went away. These risks were always lurking in the background, waiting to re-emerge, if and when there was a new catalyst.

It’s no accident that the market’s inflation forecast is falling again amid the new turmoil of confidence. As of Friday’s close, the yield spread between the nominal and inflation-indexed 10-year Treasuries is 2.26%. That’s not threatening per se. If it remained in that neighborhood it would be fine. The trouble is the trend, which lately has been down. It’s too soon to say if this new decline has legs, but it would be a dire signal if the inflation outlook continues to sink given the current climate.

As I’ve written many times over the years, inflation worries are credible—but not now. In a world still battling excess debt and a subpar economic rebound triggered by an unusually large financial crisis and a global recession, worrying about inflation was and remains premature.
Nonetheless, pundits see what they want to see. The surge in gold’s price is considered prima facie evidence in some circles that inflation is the pressing issue. But that’s only partially accurate, at best. The main reason that gold prices have been rising since 2008 is the metal’s historic role as a safe monetary haven. In that regard, gold competes with U.S. Treasuries. As such, Friday’s credit downgrade of Treasuries to AA+ from AAA by S&P will likely drive gold higher in the days to come. But if gold’s rise is accompanied by a fall in yield in the 10-year Note, you can bet that inflation fears aren’t driving the metal higher.
Keep in mind that the U.S. has no trouble borrowing money, as the low and falling yield on the benchmark 10-year Note reminds. In late-June, the 10-year traded above 3% vs. under 2.6% as of Friday. Inflation fears look rather subdued.
Meantime, falling prices generally threaten the economy…again. “What the U.S. can ill-afford is the decline in equity prices in view of how home prices have continued to fall,” says John Lonski, chief economist at Moody’s Investors Service. “It will reduce household wealth.”
Make no mistake: if deflationary forces continue to gain momentum, the front line in the battle to keep a new recession at bay will be one of engineering higher inflation. This can only be achieved if the Federal Reserve is willing and able to mount a credible plan to elevate prices, or at least keep them stable. In short, QE3 will be required.
The mere mention of the idea will send some observers of the economic scene into a rage. But if the outlook continues to deteriorate (i.e., inflation expectations continue descending), there’s really only one policy prescription: more quantitative easing. Granted, this is no silver bullet. But as a last effort at keeping deflation from returning, it’s the only game in town.
Yes, it’s a game with limited powers. The practical goal of QE3 would be quite modest: keep the economy from suffering deflation via buying time. In other words, keep the macro trend stable until organic economic growth is stronger.
By that standard, QE1 and QE2 have been successful. Did those program give us roaring growth that solved all our problems? No, of course not. On the other hand, we didn’t have another recession (a.k.a. a new bout of deflation). Can the Fed pull this monetary rabbit out of its hat again? There’s reason to wonder, given all the criticism of QE2.
Perhaps Bernanke and company will tell us otherwise via tomorrow’s FOMC meeting. “It won’t be a boring meeting,” notes Lawrence Creatura of Federated Clover Investment Advisers. “We’re in an entirely different orbit today than we were two weeks ago.”
In short, it’s all about growth, growth, growth, and a key part of that equation is keeping inflation above zero. This isn’t universally understood. But the truth will out, but there’s no assurance that acquiring wisdom will be painless.