Negative Real Interest Rates and Asset Deflation

I always try to separate my views of what I think the FOMC will do, versus what the FOMC should do. It’s hard for me now, because I think the FOMC is pursuing the wrong strategies. The yield curve is steep enough now, that further easing will not yield much incremental benefit. Further, a loose monetary policy only stimulates healthy areas of the economy that can absorb more borrowing, not areas with impaired balance sheets.

But what will the Fed do? Loosen. Aggressively. Don Quixote would be proud. They will make the TAF permanent and big, and the discount window will be a relic of a simpler age.

Let’s think of the short run versus the long run. In the short run, the FOMC wants to get the economy moving again, and is willing to tolerate negative real interest rates in order to do so. The Fed funds target is already 1%+ below the CPI, and the argument is over whether the next move will be to loosen 50 or 75 basis points. Negative real interest rates promote goods and services price inflation. (I don’t know about everyone else, but when filling up my gas tank nears $100 I begin to worry. Eight kids — 15-seat van, 10 cylinders…) In the long run, the FOMC will have to deal with price inflation. Even with the current yield curve, I can tell you that goods price inflation will worsen, leading to monetary tightening that will be painful, or no tightening, and inflation that rivals the 70s.

The Fed could target lending to the weak areas of the economy, while leaving monetary policy alone. That would invite charges of favoritism, which is why it won’t happen.

So, in my opinion, asset deflation will persist, and goods price inflation will increase. As for me, I will likely sell my positions in Deerfield Capital, Royal Bank of Scotland, and Deutsche Bank on Monday, replacing the exposure with an index for now. I have agonized over the seemingly cheap capital markets names for some time now, and I have been the loser there. I will return, but for now, it is safer to have no investment banking or mortgage exposure. The asset deflation is hitting them hard, and lending is contracting.

Full disclosure: long DB RBS DFR