Deflation, Not Inflation, Is the Fed's Big Threat

It was little surprise to me that the Federal Reserve announced today that it will not raise interest rates in June. In fact, the Fed gave no definitive timeline for a rate hike, but many market watchers presume the first bump will come in September.

The Fed wants more time to watch how things pan out.

There's good reason for the central bank's hesitation. According to the latest “nowcast” from the Atlanta Fed, first-quarter gross domestic product could come in at just 0.3%.

Given the continued weakness in the economy, tepid wage growth, plunging oil prices and the tendency toward deflation, a rate hike seems imprudent to me. In fact, in normal circumstances, a rate cut would be more likely.

But these aren't normal times we're living in.

One of the core problems confronting central banks around the world is a lack of consumer demand, which is leading to weak economic growth, low inflation and even deflation.

When inflation in the US was very high in the late '70s and early '80s, Fed Chairman Paul Volker raised rates repeatedly and vigorously to crush it, and the strategy worked.

In a time of low inflation, or even deflation, the opposite tactic (cutting rates) is typically employed. However, the US has been living with near-zero interest rates for over six years. There is little room left to maneuver without going into negative territory.

While low interest rates generally stimulate the economy, they have not really stimulated demand in recent years. Cautious consumers are wary of spending and have not been compelled to borrow at previous levels. After all, excessive borrowing is what ultimately blew up our economy in 2008.

People haven't forgotten that yet.

Perhaps they expect a crisis event, such as another war or market crash. One way or the other, people aren't spending strongly enough to reinvigorate our consumption-based economy.

Inflation over the past 12 months turned negative (0.1%) for the first time since 2009. With the menace of deflation becoming all too real, how will the Federal Reserve respond?

There is a fairly recent precedent for cutting rates to fight the specter of deflation.

The Federal Reserve cut its key interest-rate (the Federal Funds Rate) to 1% in 2003, which at the time was its lowest since 1958.

But as the Wall St. Journal noted at the time, "Below 0.25%, the market for Treasury bills, eurodollars and other short-term IOUs would function less smoothly."

Therein lies the problem: The Federal Funds Rate has been at 0.25% since December 2008.

A quartet-point reduction, which is the minimum level the Fed will typically raise or lower rates, would result in zero — no interest at all. That could kill the bond market, but it might just might stimulate the precious metals markets.

After all, why keep money in the bank if it earns nothing?

But what about rates of less than zero, as is the case at some European banks at present? Central banks cannot easily push their policy rates into negative territory.

Gold may not earn interest, but zero interest it still higher than negative interest.

Deflation is worrisome because falling prices make it hard for the government and companies to repay debts. It leads to falling wages and layoffs, and can be the prelude to a bad recession. Once it takes hold, deflation is very difficult to defeat, as the Japanese can attest.

Former Fed Chairman Alan Greenspan said in 2003 that the serious consequences of deflation required a wide "firebreak" against it and that the Fed would "lean over backwards" to prevent it.

Inflation is generally perceived as rising prices, while deflation is the opposite. However, while inflation is really a decline in the purchasing power of the dollar, deflation is ultimately an increase in the purchasing power of the dollar. That makes the current environment all the more troubling.

The dollar is at its highest level since 2003. In fact, the dollar is now reaching parity with the euro, after being less valuable for many years.

So, what's the Fed to do about this?

An interest rate hike would just make the dollar even stronger against other currencies. That would hurt the US export market even more than it's already hurting. It would also make American-made goods less competitive at home against cheaper imports.

An interest rate hike would also add to deflationary forces. In simple terms, a stronger dollar increases the risk of deflation.

A strong dollar makes imports cheaper, most critically oil. Cheaper oil lowers the cost of all transported goods, which means essentially everything.

Cheap oil is already a prime deflationary force. Crude plunged below $43 a barrel on Monday, the lowest price since 2009.

Deflation is the biggest fear of both governments and central bankers. But the primary means to fight it — a cut in interest rates— may not be that effective since we're just a quarter-point away from zero.

The possibility of negative interest rates should concern everyone. There is, however, current precedent; it's happening right now in Europe.

It costs money to leave deposits at some European banks. In essence, a depositor's principle is guaranteed to lose value.

That's something most Americans can't even imagine.

But neither could most Europeans, until recently.