"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.

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