The US does not have any measurable inflation pressure now nor has it had any over the last 20 years. The core personal consumption price index, used as the benchmark for inflation by the Federal Reserve (Fed) has been in the 1.25% to 2.5% zone since 1994, averaging about 1.75% for the last 20 years, and drifting down to an average of about 1.25% over the last six months. This has been true despite three bull markets in equities – the technology-led rally of the 1990s, the housing boom of the early 2000s, and the post-2008 financial crisis QE-induced bull market. Not even the last five years of historically accommodative monetary policy with a near zero federal funds rate and massive central bank asset purchases has been able to kindle inflation pressure. The same is true in Europe, where there are fears of sliding into deflation. And in Japan, the Government is struggling to break the back of the country’s deflationary psychology and eke out a 2% inflation rate by 2015.
Even in the housing boom of 2003-2007, when US bank loans and leases were growing at around an 8% rate, core inflation never breached 2.5%. With bank loans growing at only a 3% pace over the last several years, it is hard to see inflationary pressures gaining any traction. The Fed may be buying assets at a record pace of over a trillion dollars per year at an annualized rate ($85 billion per month), but the Fed also pays 0.25% interest on both required and excess reserves, giving banks a tiny, yet positive premium over the effective federal funds rate in the open market. Moreover, large corporations are sitting on record cash hoards in no small part because the long-run environment is so uncertain. And, the US Congress with its brinkmanship over the debt ceiling and willingness to shut the government down probably should get a reasonably large share of the blame. In short, much faster, probably +10% annual growth, in commercial and industrial bank loans is probably a pre-condition for the development of inflationary pressures in the US.
Then there is the matter of the reinforcing effect from the currency markets. A weak dollar helped to feed inflation in the 1970s, and a strong dollar help cure it in the first half of the 1980s. With all the major industrial countries in the same boat, with less than optimal economic growth, and near-zero short-term rates, no currency trends have developed to push inflation higher (or lower). In Japan, round one of Abenomics saw the yen depreciate 20% from below 80 yen/$ to the 100 yen/$ range, but the yen has been quite stable since that early move ended last April.
The Fed’s dilemma is to reconcile the lack of evidence that its QE programs created jobs or moved the needle on inflation, with the fact that the size of the central bank’s balance sheet is getting quite worrisome. Before the 2008 financial crisis, the size of the Fed was around 6% of nominal GDP, and now it is about 25% and climbing. The next three FOMC meetings, on 17-18 December 2013, 28-29 January 2014, and 18-19 March 2014, are not only likely to see Ben Bernanke hand the gavel over to Janet Yellen, but also see the internal debate become much more rancorous concerning the appropriate size and role of the central bank. More than a few Fed Governors and regional Fed Presidents are likely to argue that the central bank needs to recognize the limits of what it can accomplish, given the headwinds from fiscal tightening, Congressional-induced economic uncertainty, and a slower growing labor force that is aging as well. All of these concerns will make for an exciting debate and are likely to lead to more volatility in both US Treasury bond and equity markets than have been the case during the QE era when volatility has been suppressed artificially.
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