FED FOCUS-Ebbing deflation risk poses Fed policy conundrum

By Pedro Nicolaci da Costa

WASHINGTON, Nov 2 (BestGrowthStock) – Early strides in the battle
against deflation could make Ben Bernanke’s Federal Reserve a
victim of its own success.

The Fed has already sparked a pick up in bond yields and
inflation expectations just by laying the groundwork for a new
bond buying program.

Those very gains could thwart the consensus for a larger —
and potentially more effective — second round of purchases.

“The Fed has succeeded in lifting expectations of inflation
and that has actually reduced the risk we’ll get deflation,”
said Michael Moran, chief economist at Daiwa in New York.

“But they still have to go through with it. They have to
ratify the expectation that’s been built into the market.”

In laying out the rationale for a new monetary stimulus
effort, Bernanke emphasized the risks posed by uncomfortably
low inflation, phrasing the argument in terms even the Fed’s
more hawkish members can get behind.

However, this sort of specificity has its downsides. In
anticipation of another installment of Fed bond buys expected
to total at least $500 billion, the market’s implied inflation
premium has been drifting higher, pushing up prices of global
stocks and commodities in its wake.

The underlying inflation trend also appears to have
stabilized, albeit at levels considered too low for some at the
Fed. The central bank’s preferred core inflation measure rose
just 1.2 percent in the year through September, down from 1.3
percent in August but hardly in deflationary territory.

“We haven’t seen an acceleration in the decline, so the
risk of a very near term disinflationary environment seems to
have subsided,” said Ian Lyngen, senior government bond
strategist at CRT Capital Group in Stamford, Connecticut.

DEFLATED RISKS

Estimates from the Atlanta Federal Reserve Bank suggest the
risk of deflation has receded from about 27 percent in late
September to around 22 percent today. A recent study from the
San Francisco Fed was even more sanguine, indicating only about
a 5 percent risk of an outright drop in average prices
throughout the economy from now through 2013. [ID:nN25275536]

That’s great news of course, and should give Fed officials
increased confidence about their ability to support a flagging
economy going into a two-day meeting that will end with a
keenly awaited decision on Wednesday.

Indeed, refuting the notion that the Fed is out of
ammunition, St. Louis Fed President James Bullard has
repeatedly pointed to moves in financial markets in
anticipation of further easing as a clear sign that policy can
in fact work even with official rates near zero.

In one particularly striking example, the Treasury last
week issued inflation-protected securities with a negative
yield for the first time ever. That suggested investors are
anticipating enough inflation in the future to be willing to
pay the government for that protection today.

The gap between nominal five-year Treasury yields and those
on inflation-linked notes of the same maturity has widened to
about 1.65 percent from as low as 1.25 percent in August.

THE HARD PART

The problem for the Fed is that inflation and unemployment
are not exact mirror images. In other words, just because the
Fed is able to engender expectations of higher prices, does not
mean this will translate into the sort of employment gains that
can put the economic recovery on a sustainable path.

“With both employment and inflation below target, the Fed
can aim to raise both — and finds it harder to justify
inaction,” said Marco Annunziata, chief economist at UniCredit
Group in London. “Raising inflation, however, is going to be
much easier than raising employment.”

At 9.6 percent, the country’s stubborn jobless rate has
refused to budge, hovering near its worst levels in around 30
years for several months now. Even more worrisome, long-term
unemployment is at unprecedented levels, making a vicious cycle
of joblessness more likely.

If inflation does pick up appreciably, investors can expect
an already loud chorus of opposition to easier monetary policy,
within and outside the Fed, to get even more vocal.

Thomas Hoenig, president of the Kansas City Fed, has dubbed
the Fed’s ultra-low rates policy a “dangerous gamble.” He is
not alone in that view. Higher inflation expectations could
convince swing voters on the Fed’s policy committee to line up
behind Hoenig in dissent.

That could undo some of the heavy lifting accomplished by
Fed jawboning and, paradoxically, return the prospect of
deflation to the market’s radar screen.

FED FOCUS-Ebbing deflation risk poses Fed policy conundrum