"One has to belong to the intelligentsia to believe things like that.
No ordinary man could be such a fool."
-- George Orwell

The famed author of 1984 and Animal Farm and satirist of political doublespeak would feel right at home discussing the Federal Reserve and its panicked assault on a deflation that may or may not exist and may or may not be "good" deflation if it does.

Good deflation, for purposes of definition, is prices falling due to increases in productivity -- think computers and long-distance telephone service -- while bad deflation is prices falling due to a collapse in demand.

It wasn't that long ago, November 2001 by my count, that the Federal Open Market Committee was congratulating itself for being sufficiently accommodative and opining that the risks were balanced between slowing growth and rising inflation. More recently, Sir Alan Greenspan was pontificating about a "soft patch" in the economy, whatever that is or could be.

The job of a central banker is to promote price stability, not to engage in the Orwellian worry of whether inflation isn't high enough. A dollar in my birth month of August 1954 is worth only 14.68 cents today on the basis of consumer prices, and that is prima facie evidence that the Fed has failed in its primary task.

The measure of the failure is independent of the yardstick, be it the producer price index, the consumer price index or the personal consumption expenditure deflator.

Is This Price Stability?
Source: Bloomberg

More important, no evidence exists that a deflationary cycle can be broken by monetary policy alone, and that raises the very real risk that the Fed is going to create all sorts of other problems by persisting in its present course without actually forestalling deflation. The precedents are grim: Only World War I broke the deflationary pressures of the end of the 19th century, and only World War II broke the deflation of the 1930s. Japan's postbubble deflation persists despite near-zero interest rates and a breathtaking level of public debt.

Which Market Leads?

The question addressed here last week, whether stocks or bonds are the more predictive market, slightly but inconclusively favored stocks as the more foresighted market. Let's take a look at the question from another perspective, whether stock prices or Treasury yields are better leading indicators of two key macroeconomic variables: unemployment and industrial production.

Before we begin, we should establish that the abrupt lurches that have characterized monetary policy have had less effect on real equity prices than is commonly supposed. We can measure the steepness of the yield curve by taking the ratio of the forward rate from six months to 10 years -- the rate at which we can lock in a note rate starting six months from now -- to the 10-year note rate itself.

If this ratio is compared with the logarithm of the deflated S&P 500, we see almost no discernible pattern of causality. The late-1990s bubble occurred in the face of a flattening yield curve. The recent bear market has occurred in spite of the most panicked reaction on the part of the Fed since 1958, a year which seems to be getting a lot of attention in interest rate circles of late.

Steeper Yield Curves Don't Help Stocks
Source: Federal Reserve, TSC Research

If the stock market in turn is supposed to discount future corporate earnings, we in turn should conclude that all of the Fed's histrionics and incantations have no effect whatsoever on the real economy. Let me repeat, none. They have no more effect than a Stone Age shaman in New Guinea does in leading a cult ceremony, and while my basis for comparison is somewhat incomplete, I suspect they are less entertaining. And yet we let the FOMC play with matches.

Comparative Prediction

In testing for whether either market can forecast industrial production or unemployment, we once again will use the concept called Granger causation. Just like last week in our discussion of stocks and corporate bond spreads, we have to conclude that neither market is truly causative.

However, stocks once again get the advantage. Returns on the deflated S&P 500 lead changes in industrial production and unemployment with lags of three and seven months, respectively, with R-squares of 5.70% and 2.93%, respectively.

Returns on 10-year notes had much shorter leads, one month and no lag, respectively, and R-squares of 0.48% and 0.57%, respectively, for industrial production and unemployment. Both macroeconomic variables explained themselves -- autoregression -- at much higher R-squares, 10.50% and 7.41%.

Edge for Stocks
Ind. Prod Unemployment
10.50% 7.41%
Cross Dependent
Independent Ind. Prod Unemployment
S&P 500 5.70% 2.93%
Ten-Year 0.48% 0.57%
Source: TSC Research

The first two tests of stocks and bonds indicate that when the two diverge, stocks should be given the benefit of the doubt. In the present situation, this means we should be placing greater faith in the combination of stronger equities/weaker dollar/narrowing corporate bond spread than in the giddy Treasury rally.

Yes, you can pour your life savings into 10-year paper yielding less than 3.5%, fully taxed and with no protection against inflation should it recur as a problem, which is still my bet. Implicit in this investment is a belief in the powers of the Federal Reserve to affect the world as it intends. At this point, I would recommend abandoning Orwell as a political philosopher and following the teachings of Clint Eastwood: How lucky do you feel?

Howard L. Simons is a special academic adviser at Nasdaq Liffe Markets, a trading consultant and the author of The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. The views expressed in this article are those of Howard Simons and not necessarily those of NQLX. As a matter of policy, NQLX disclaims the private publication of materials by its employees. While Simons cannot provide investment advice or recommendations, he invites you to send your feedback to Howard Simons.

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