Fed deflation-fighting weapons - weak dollar & inflation expectations
US core inflation is at its lowest level since 1961, and we believe it is headed toward zero unless the US Federal Reserve (Fed) fights hard against the downward pressure. With no direct control over the hefty spare capacity that is weighing on core inflation, we expect the Fed to deploy a combination of two weapons left at its disposal – a weaker dollar and higher inflation expectations. In our view, big moves are needed, which will have significant investment implications.
The output gap, which impacts core inflation with about a one-year lag, is a useful way to forecast changes in core prices. As long as growth remains at or below its longer-term trend, or average, a significant output gap (i.e. spare capacity) will remain. Given our long-held and now consensus forecast for below-trend US growth this year and next, this suggests continuing downward pressure on core inflation, currently at 0.8%, through 2011.
Judging from the change in the language over the past few weeks, Fed officials are increasingly worried about the weakness of the recovery and threat of deflation, or falling prices. Without a further round of bond purchases, or quantitative easing (QE2), we estimate core inflation would probably reach zero in the first half of next year. We would then expect it to turn negative by the end of 2011.
Assuming the output gap remains constant, our analysis suggests the Fed could increase core inflation to its unofficial target range of 1.5-2.0% in the following ways: a 50% year-on-year (yoy) depreciation in the dollar against a trade-weighted index; an increase in inflation expectations of 3.2 percentage points (pp), from the August low of 1.5% to 4.7%, or some combination of the two. The magnitude of the move that would be needed in the dollar by itself, and the trade war that would likely ensue from such an aggressive depreciation, make this option unrealistic. A combination of dollar weakening and increasing inflation expectations, such as a 25% yoy dollar depreciation and 1.5 pp increase in inflation expectations, is much more likely, though still large. If, on the other hand, the Fed were to merely stabilise core inflation around current levels, rather than bring it back within the target range, they would need to combine inflation expectations increase of about 0.7-1.2 pp with respective dollar declines of 15%-8% yoy.
In any case, history suggests there would be a lagged effect on core inflation of at least three quarters and 6-7 quarters from changes in inflation expectations and the dollar, respectively. Anticipation of the Fed announcing substantial bond purchases after its 3 November meeting has already pushed the dollar lower and inflation expectations higher in the past few weeks.
As such, further quantitative easing will probably need to be extremely large and open-ended to have any further impact on the dollar and inflation expectations.
High-yielding assets and gold remain attractive
Barring such a move, the risks remain skewed toward further declines in inflation for the time being. We are maintaining our forecast for core inflation to fall close to zero by mid-2011. This should keep interest rates and bond yields at their extreme lows, and continue to support demand for higher-yielding assets in the near-term. But we believe the Fed will continue to pursue an increasingly aggressive and unconventional monetary policy in 2011 in an attempt to push up inflation expectations. This supports our view that alternatives to paper money such as gold will continue to make gains.
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