The first big test of the Fed’s latest phase of monetary stimulus (a.k.a. QE2) begins, well, now.

The jury’s still out on the final verdict, but for the moment the disinflation momentum of the summer remains nipped in the bud. But it’s a precarious stability. As of yesterday, the implied inflation rate based on the yield spread between the nominal and inflation-indexed 10-year Treasuries was just under 2%. That’s down a bit from last week. Should we be concerned that a new downturn in the expected pace of inflation is coming? Yes, or at least that’s the fear, even if it’s not obvious that this is destiny. Indeed, the Fed is working overtime to prevent this outcome and so the odds are low that we’ll see a revival in the disinflation trend. But low odds aren’t zero odds.

The key factors that keep the risk of disinflation/deflation alive are the usual suspects that have been with us all along: lots of debt weighing on the economy and sluggish growth. The good news is that the economic news has been modestly brighter recently.
Retail sales for October, for instance, perked up by a better-than-expected 1.2% vs. September, led by a 5% surge in auto purchases. That translates into a gain in retail sales by more than 7% on a year-over-year basis, a sign that the economy is recovering. Job growth last month also surprised on the upside, with nonfarm payrolls rising by a net 159,000 in October, the best month since April.
But it’s too soon to sleep easy. For starters, the inflation outlook in the Treasury market has, for the moment, topped out at just over 2% and is again slipping. It’s too soon to say if that’s just statistical noise in an otherwise stable state, or the start of another decline.
Keeping investors on edge about what happens next is the revival of contagion fears regarding debt worries in Europe. The latest concern is Ireland, which is struggling to manage its mountain of red ink. “There is so much uncertainty” surrounding the Irish debt situation, John Stopford, head of fixed income at Investec AM, tells Reuters today. “It is making a speculative decision on political decisions. We need a lot more clarity on how this is going to work out over the next five years.”
Adding to investor anxiety at the moment are reports that China’s prepared to fight rising inflation in its economy by raising interest rates. In turn, that raises concerns for the pace of growth in the global economy, which has relied heavily on emerging markets. “China coming back with tightening talk is making the market nervous again,” opines Nader Naeimi, a Sydney-based strategist at AMP Capital Investors Ltd. “All the fears are back over China going too far, and what that will do to growth in the region. It’s giving investors the excuse to lock in profits,” he explains via Bloomberg.
Contagion worries on the global stage are very much front and center again, warns Bruce McCain in the investment department at Key Private Bank in Cleveland. As he advises in today’s Wall Street Journal: “All of this is raising the question about how sustainable this economic expansion is from here, both in the U.S. and globally. The fact that we have run stocks up since June just leaves the market open to the normal anxieties about whether we have come too far too fast.”
Indeed, U.S. stocks and commodity prices tumbled yesterday. Another sign that the global appetite for risk is waning is the dollar’s strength this month. The U.S. Dollar Index has climbed more than 3% so far in November. That’s surprising, given all the chatter that the Fed’s QE2 is destined to weaken the greenback.
Make no mistake: the U.S. economy is at a delicate point. The economy is on the mend, but it’s a weak revival. It’s picked up some speed in the last few months, although that’s notable primarily because the imminent risk of a new recession has faded. That’s quite a bit different than saying that the growth outlook has radically improved. Meantime, even the minimal improvement is vulnerable.
All bets are off if the disinflation trend picks up a new head of steam. That’s unlikely, at least based on current data. But in a world burdened with a heavy debt load, weak growth, and wobbly optimism on the macro outlook, it’s premature to assume that the future is clear. In fact, the Philadelphia Fed’s newly published fourth-quarter survey of 43 economic forecasters reminds that there’s still plenty of anxiety about the strength of the economic recovery:

The pace of recovery in output and employment in the U.S. economy looks a little slower now than it did three months ago, according to 43 forecasters surveyed by the Federal Reserve Bank of Philadelphia…The forecasters also predict weaker recovery in the labor market.

Sure, there’s an encouraging history of central banking’s use of quantitative easing to juice economies in recent history around the world, according to a report the St. Louis Fed. But the only thing that matters now: the real-time numbers in the economic reports. As usual, they drip out slowly, one statistic at a time.
It’s going to be a long winter…again.