Fed Accelerating Commodity Deflation
Alvexo | Jul 30, 2015 11:19AM ET
Federal Reserve efforts toward monetary policy normalization have hit a critical juncture ahead of September’s meeting. Although the benefits of raising interest rates are substantial, it is not without risks to both the US economy and the larger global economy. There is already much speculation that efforts to hike interest rates will be met with a volatile response from financial markets after six years of extremely loose policies. While this is a well-founded concern, it should not be used as rationale to keep existing policies intact. The window for the Federal Reserve to hike rates is closing fast and the Central Bank will require tools to fight another crisis when it emerges. At the zero bound, the only tools left include taking interest rates into negative territory, an experiment already conducted by the Swiss, Danes and Swedes, or a resumption and expansion of quantitative easing.
Yesterday’s policy decision could be viewed widely as a non-event after the Federal Open Market Committee voted unanimously to keep interest rates on hold. While it raises the specter of September liftoff, there are still some unknowns that are weighing on the outlook, namely the non-anchoring of inflation. According to the latest CPI and PCE numbers, inflation is no closer to the Federal Reserve’s medium-term outlook. Now that commodities, and energy in particular are trending back to the downside, it means that inflation could become further unhinged, slipping into deflationary territory. Classical Keynesian economists know this is a recipe for disaster, as raising rates in an environment of below-trend growth and weak inflation could exacerbate underlying fundamental issues. While the Federal Reserve was able to prevent a hyperinflationary spiral during the quantitative easing experiment, whether or not it will be able to stave off a deflationary spiral remains to be seen.
Today’s preliminary second quarter GDP numbers saw a blockbuster 2.30% reading, printing well above the first quarter’s -0.20% contraction. Although not the final reading and below the initial estimates of 2.60%, it nevertheless sets the stage of a September or December hike depending on the outlook for inflation and the labor market, though the latter continues to show promise. The latest initial jobless claims are hovering very close to 42-year lows and nonfarm payrolls next week could give the Federal Reserve the necessary ammunition to satisfy the “further job market improvement” the Central Bank so desperately seeks. Fed Chair Janet Yellen knows that employment figures do not necessarily reflect the slack evident in the labor market, according to the latest labor force participation level. Apparently cooling the bubbles in housing and stocks takes precedence at the Federal Reserve versus the stated objectives of full employment and inflation targeting.
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Continued momentum in job creation is going to be a crucial item to watch next week as the “data dependent” Federal Reserve relies on strengthening figures to buoy the liftoff outlook. However, in the meantime, the dollar continues to improve after reversing higher following the softness experienced earlier in the week. Expectations for September are increasingly positive, especially when considering today’s preliminary GDP numbers. The dollar rally that started last summer is now in full effect and likely to persist through the end of 2015 as he normalization process gains momentum. The dollar remains one of the strongest determinants of the outlook for many other asset classes, most notably commodities. To a certain degree, the strong inverse correlation is contributing to the deflationary forces currently acting upon commodities.
Looking at the commodity complex specifically, there is already price deflation occurring across the asset class with prices of certain commodities falling below extraction costs. The ascension in the dollar is broadly contributing to the losses especially in precious metals and energy commodities. Today’s price action is further evidence of the relationship between the dollar and dollar-priced commodities as gold and oil reverse from earlier gains. The stronger dollar narrative is likely to persist, meaning prices could easily fall much further, though at times the correlation proves looser than currently witnessed. What is most concerning about commodity deflation is that it underlines the prevailing feebleness in global trade dynamics and could be largely indicative of another impending recession. If the Federal Reserve decides to act now to give itself breathing room ahead of the next crisis, it might be building a self-fulfilling negative feedback loop that actually forms the basis for the next global downturn.
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