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Deflation: Now a European Problem, Too
Despite the Fed’s expansive balance sheet, it's not inflation U.S and Europe need to worry about.
The winds of deflation are blowing in Europe, and Jean-Claude Trichet, European Central Bank president, is at the helm of the economic ship, desperately hoping to avoid the shoals of policy error. Trichet does not need a GPS unit or navigational charts to see the rocks, because the wreck of the Federal Reserve lies just ahead and is plain enough to see.
Fed Chairman Ben Bernanke respects the economic troubles deflation can summon, but he feared depression, and in response he engineered an aggressive monetary response to sustain the U.S. financial system and keep short-term interest rates low. Bernanke was complacent when the fiscal stimulus package was passed in January 2008, and now the 2009 U.S. budget deficit is forecast to be 13% of GDP and account for nearly half of government spending. The Congressional Budget Office projects trillion-dollar deficits as far as the eye can see and a gross federal debt above 100% of GDP by 2017. On top of that, the U.S. faces a renewed credit crisis over the next year in a massive set of Alt-A mortgage resets and hundreds of billions in commercial real estate rollovers due. Job losses in the U.S. are at a pace to move above 10% unemployment in the next 6 months, and mortgage delinquencies continue to rise.
If this is not a shipwreck, then I do not know what is.
Yet, despite the massive increase in the Fed’s balance sheet, I see little inflationary pressures, in the U.S or Europe. While consumer spending in Germany has held relatively firm, that cannot be sustained. Deflation is coming to Europe too, and we will now see if the ECB can deftly maneuver through the policy trap of massive deficit spending to avoid an even deeper recession.
The calls for bailouts, protectionism and stimulus spending are already making for choppy political seas in Frankfurt. German bonds have been a far superior investment over U.S. Treasuries because of the lack of action by the ECB. But should that change, then bets against the Bund, and the recovery for Europe, could pay off handsomely.
This essay originally appeared on the June U.S. Treasury daily forecast page of Bill Fox’s intensive Interest Rates Specialty Service. (What are EWI's Specialty Services?)
Bill Fox has been involved in the markets since graduating in 1988 from Vanderbilt University. He joined EWI in 1994; most of his subscribers are professional traders spread around the globe.