The Fed changes its tune as deflation gains the upper hand

Throughout the first quarter of 2013 the speeches and sound bites coming from the various heads of the US Federal Reserve had a distinctly hawkish tone. Over the past few weeks however, the talk of a Fed exit strategy and the early curtailment of QE has been replaced by more dovish talk of the need for continued stimulus and fears of deflation.

As Michael Pento, President of Pento Portfolio Strategies, explained in a recent article, “Industrial and growth stocks are plummeting across the board. For example, Caterpillar (CAT) is down 20 percent in the last 30 days, base-metal commodities are headed into bear market territory and copper is down 15 percent since February and is now trading at a over a 52-week low. Oil is also dropping sharply of late, falling down to $86 per barrel from the mid-90s a few weeks ago. Also, the recent stock market rally has been very narrowly based. Those equities that have been working are defensive in nature like healthcare and consumer staples… that is not representative of a healthy market”.

The recent bad news in the markets was also accompanied by disappointing growth in the Chinese economy and yet another downgrade of growth in the Eurozone.

All of this points to the fact that deflation is gaining the upper hand, and that the Fed (and other central banks) may need to keep the printing presses running longer than they had originally hoped.

Two weeks ago Fed President Charles Evans suggested that that the Fed should continue its QE program until the US unemployment rate reaches 5.5%, 1% lower than the current target. This week we heard further dovish comments from Evans with him stating that, “I continue to see the need for asset purchases with high probability into the fall of this year.” He also noted that any “winding down” of the Fed’s asset purchase program is likely to continue into 2014.”

There were also comments from William Dudley, President of the New York Fed, and James Bullard, President of the St. Louis Fed. Dudley commented that he sees “the current pace of asset purchases as appropriate”, while Bullard noted that “inflation is pretty low right now, and it’s been drifting down”. Asked what he would do if the inflation rate in the US dropped further, he said that he would recommend that the asset purchase program be ramped up.

The battle between the forces of inflation and deflation continues and the reality is that without continuous support in the form of massive money printing the US economy would quickly slump into recession or even a depression.

As Michael Pento concludes, “investors need to buckle their seatbelts because major global economies will be whipsawed between inflation and deflation until they finally crash due to bond market meltdowns”.

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