The real worry is deflation Published: 2022-07-23

Prices are at 40-year highs

Inflation talk is all the rage right now, and for good reason. Price increases are at 40-year highs, and most people alive in the US and elsewhere have never experienced anything like this in their lifetimes.
The chart below shows the extent of the damage. Even excluding food and energy, the price increases have been nothing short of spectacular.

Fed response

The Federal Reserve has responded by aggressively raising the Fed Funds Target Rate, their key interest rate tool. They have been quite successful at slowing the housing market, which is the main way they influence the economy.
The correlation between the 10-year Treasury yield and the 30-year mortgage rate is quite high. Notice in the graph below how the mortgage rate and the 10-year move in virtual lock step.
Another thing to notice in this graph is the 10-year yield minus the 2-year yield, the dashed red line. During normal times interest rates for longer dated securities are higher than shorter dated ones. When the dashed line goes below the zero line it's called a yield curve inversion, which is actually quite rare. When this happens it's an indication that the bond market is expecting an economic slowdown and its participants are buying the safety of longer-dated 10-year Treasurys. It doesn't always presage an actual recession, but its track record is really good at predicting slowdowns.

Limits of monetary policy

The Fed can certainly affect demand by raising interest rates (especially in housing as mentioned previously), but it is MUCH more difficult for them to affect supply. Prices can go up for many reasons, and there have been many important reasons why over the last two years. Initially the pandemic caused prices to plummet as economies shut down worldwide. Governments around the world responded by supplying fiscal stimulus, and many monetary authorities including the Federal Reserve continued to supply monetary stimulus as they had been doing for years.
Fiscal stimulus has a much more direct effect on economic activity and the results were spectacular. Demand soared (from the lows) and the economy chugged along (what recession?). The fiscal stimulus certainly saved the world from a prolonged and deep recession.
The globalized economy is a wonder to behold when it works, but supply bottlenecks began to appear. Limit the supply of anything with demand kept constant and prices will inevitably rise. And did they ever. 

Typical result

In typical fashion, policy makers have responded too aggressively. Prices for most commodities fallen drastically over the last few months as traders anticipate demand destruction. The chart below shows a broad non-fuel commodity index. Prices for energy have stayed stubbornly high mainly because of the Russia/Ukraine conflict. China's recent massive lockdowns certainly didn't help with the supply situation. Again, raising interest rates can't force China to open up, and they certainly can't stop a war. All they can do is stifle demand for key assets.

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Political will

Politicians are not going to save the day with the demand destruction occurring now and in the months ahead. It's actually amazing that they were able to pass the fiscal stimulus measures in March of 2020. Automatic stabilizers like unemployment compensation will help to smooth things out as they always do, but it looks like the US economy is slow walking toward recession.

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This article was written by: Anonymous
  • The author does not have a financial interest (stocks, options, other) in any companies mentioned in this article.
  • The author has indicated that this article is an original work. It expresses their opinions.
  • The author does not have a business relationship with companies mentioned in this article.

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