Posted 5 years ago on Nov. 25, 2012, 3:04 p.m. EST by richardkentgates
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In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% (a negative inflation rate). This should not be confused with disinflation, a slow-down in the inflation rate (i.e. when inflation declines to lower levels). Inflation reduces the real value of money over time; conversely, deflation increases the real value of money – the currency of a national or regional economy. This allows one to buy more goods with the same amount of money over time.
Prior to the financial markets' obsession over the looming fiscal cliff, their single-minded focus was on monetary policy. Now, two months after the Federal Reserve announced its so-called QE3, its third round of quantitative easing, it appears the fuss was much ado about very little.
Ben Bernanke seems to be losing his battle with deflation, observes Walter J. Zimmerman, chief technical analyst for United-ICAP. So far, the Fed's scheme announced in September to buy $40 billion of mortgage-backed securities for however long it takes to lower unemployment has little to show for it. Quite to the contrary, market prices show the U.S. central bank has shown itself impotent in its fight against the undertow of deflation.
Global stocks and commodities are down significantly from their peaks reached in mid-September while the dollar has strengthened, he points out. That is contrary to the record of QE1 in 2009, QE2 in 2010 and so-called Operation Twist (the Fed's purchase of long-term Treasuries and offsetting sales of shorter-dated maturities) beginning in 2011. While the first two iterations of QE boosted stock and commodity prices and lowered the dollar significantly from their outset, the markets have done the opposite under QE3.
Zimmerman writes the Standard & Poor's 500 rose some 63%, or 5.3% per month, following QE1. After QE2, the S&P 500's cumulative gain was 9.7% or 1.4% per month. Operation Twist produced a 30% gain, or 2.7% per month. In the two months since QE3, the S&P 500 was off 6.9% as of Friday.
True, the equity market has had to fight the tide of slowing corporate earnings and the political uncertainties of the elections and the looming fiscal cliff. But the decline since the implementation of QE3 also shows that money printing can't cure all economic ills.
Not even those at which the policy is aimed most directly. The Fed's purchase of mortgage-backed securities is explicitly designed to bring down home-loan interest rates and thus stimulate the residential-property market. That had always been the magic elixir for the economy in past cycles; Fed easing would lower mortgage yields, which would spur housing as well as refinancing activity that would put more cash into homeowners' pockets. The combination was always a potent cocktail that could be counted upon to get the economy hopping.
In this cycle, the effect of the Fed's shot of whiskey has been dulled by the hangover from the crash after the bubbles of the last decade. Even homebuilder stocks, which have soared on the prospect of a rise in residential construction -- albeit from deeply depressed levels and only to ones that marked the nadirs of previous cycles -- are beginning to roll over.
Monday, D.R. Horton (ticker: DHI) saw its stock fall nearly 6% despite strong quarterly earnings and revenues while Beazer Homes USA (BZH) plunged 17% on a bigger-than-expected quarterly loss even with revenues that exceeded analysts' forecasts. The limits of the Fed's ability to boost housing activity are becoming apparent.
Where the Fed can claim some measure of success is in bringing down corporate-bond yields. International Strategy & Investment points out medium-grade (Baa by Moody's) corporate yields fell to a record low of 4.22%, down 190 basis points (1.9 percentage points) from their peak last year. Similarly, comparable European corporate-bond yields are down a huge 430 basis points from their peak last year, to 3.72% -- a "big win" for the European central bank, ISI adds.
These victories accrue to large corporations that can tap the bond market for hundreds of millions or even billions at a pop. And just as bankers will only lend money to somebody who doesn't need it, the bond market is open to companies with tons of cash already on their balance sheet but want to take advantage of record-low interest rates to refinance old debt or to buy back stock, perhaps even pay out more in dividends. But the cheap financing is not spurring expansion of plant and equipment as capital spending rolls over amid excess capacity in many industries.
Governments are the other great beneficiaries of the bond market's beneficence -- for now. There has been no penalty for the U.S. hurtling toward the fiscal cliff -- and more potential downgrades of its remaining triple-A ratings from Moody's and Fitch after last year's cut by Standard & Poor's -- while the Treasury can borrow at record-low interest rates. The so-called bond vigilantes of yore -- who in the 1980s and 1990s sharply boosted interest rates at the first sign of inflation -- are overcome by the central bank's purchases of the securities that finance the budget deficit. So, Bernanke & Co. are enablers of the dysfunction in D.C.
But, the signs are building that even the Fed is failing in its main aim of QE3, the blunting of deflationary forces. Along with equities, Zimmerman points out that even the DJ-UBS Commodity Index is down 8.4% since the mid-September announcement -- a sharp contrast to the 42% total rise after QE1, the 23% pop after QE2 and the 8.6% gain after Operations Twist.
At the same time, the U.S. Dollar Index has rallied 3.2% since the start of QE3, also the reverse of the 8% drop under QE1, the 5.5% fall under QE2 and the 1.2% dip under Operation Twist. Zimmerman also points to the diminishing returns from each round of Fed easing apparent in these data.
Monetary expansion is a necessary, but not sufficient, ingredient for economic expansion. The classic Keynesian remedy for the so-called liquidity trap -- in which borrowers won't borrow and lenders are loath to lend even at rock-bottom interest rates -- has been for the government to run deficits to offset the surpluses in the private sector.
But, as Carmen Reinhart and Kenneth Rogoff showed in This Time is Different: Eight Centuries of Financial Folly, when government debt reaches about 90% of gross domestic product, it slows rather than boosts growth. A little debt is a stimulant; a lot is a depressant. At which point, central banks' ability to steer the economy diminishes.
Yes, it means exactly what you think. The Fed is and has been knowingly preventing your paycheck from climbing in value and actively maintaining the very economic inequality that Occupy is protesting.