The jump in deflationary risk last month is still a real and present danger, if only marginally. But given the market reaction of late, it would be shortsighted to dismiss the threat. Yet there are reasons for optimism. One is that the inflation forecast in the Treasury market has stopped falling. Two, the money supply growth rate is no longer dropping like a rock.
It’s unclear if the inflation outlook will remain steady, fall or rise in the weeks and months ahead. Ditto for the rate of change in the money supply. But for the moment, there’s been a pause in downward trend in both measures, suggesting that the deflationary threat, for the moment, isn’t getting any worse. It’s open to debate if it’s getting any better, but first things first.
As our first chart below shows, the market’s inflation outlook (based on the yield spread between nominal and inflation-indexed 10-year Treasuries) has stabilized at just under 2%. That’s down from around 2.45% in late April. The drop in the inflation outlook in May coincided (not surprisingly) with a sharp decline in asset prices. Although equities and commodities have yet to recover those losses, and have fallen further so far in June, Mr. Market is no longer anticipating that the D risk is getting worse per se. That’s hardly the same thing as saying that the recent anxiety over deflation was wrong. It may be, but it’ll take time to know for sure. Meantime, the markets seem to be taking a wait-and-see approach after the recent repricing. Prices have been discounted a bit to reflect the higher D risk. The question is whether future economic reports will confirm or deny.
One reason for thinking positively is that the U.S. money supply is no longer falling at the steepest pace since the Great Depression, as it was in recent months. As the second chart below shows, M1 money supply (seasonally adjusted) rose by 3.4% in the week through May 24 vs. a year earlier. That’s well off the cyclical highs of 10% to 12% that prevailed in early 2009. But the pace now appears to have stabilized at roughly 3%-4%. A similar stability has recently arrived in the broader M2 money supply trend.
Is this a sign that the Fed is responding to the recent rise in deflationary risk? Perhaps, although the trend bears watching over the summer. Pressure is mounting for the Fed to raise interest rates and generally begin the process of implementing an exit strategy to mop up the massive liquidity injections of the past two years. For instance, consider last week’s comments from Dennis Lockhart, president of the Atlanta Fed. Although he’s not currently a voting member of the Fed’s FOMC group that sets interest rates, Lockhart speaks for many when he says…
I continue to support the current stance of interest rate policy. But the time is approaching when it will be appropriate to consider recalibrating interest rate policy. I do not believe that time has yet arrived. The conditions that require a change of policy are not yet at hand. However, as the economy continues to improve and financial markets find firmer ground, extraordinarily low policy rates will not be needed to promote recovery and will become inconsistent with maintaining price stability.
The implication is that the policy rate may have to begin to rise even while unemployment is considerably higher than before the recession. I’m very concerned about unemployment, and certainly employment trends should be a critical consideration in setting policy. But I accept that good policy, even in circumstances of unacceptable levels of unemployment, may incorporate higher interest rates.
Meanwhile, Kansas City Fed President Hoenig, who is a voting member of the FOMC, suggested earlier this month that the Fed should begin preparing to raise interest rates to 1% by the summer’s end, up from the current zero-to-0.25% target Fed funds rate that now prevails.
The worry, of course, is that the Fed has opened the door for higher inflation in the years ahead. The great question is whether the risk of deflation is the bigger threat at the moment? If so, does that require delaying the exit strategy–or temporarily accelerating the monetary stimulus? The market’s view appears to be slightly biased toward more quantitative easing, or at least delaying the inevitable exit strategy. But the market’s not necessarily making decisions at the central bank. It remains to be seen if that’s good news or not.