Unexpectedly Intriguing!

Let's say, for a moment, that you're in charge of the U.S. Federal Reserve. You assumed the top job shortly after a significant surge in prices had taken place in the United States' housing markets, but the bubble on which those prices were rising has now long since dissipated.

Your initial response to try to stabilize the markets was to try to reset the relative value of housing through inflation. By making the prices of everything else rise with respect to housing, you might be able to make housing prices stabilize at levels higher on paper than those to which they might otherwise fall, protecting the balance sheets and solvency of the financial institutions you've deemed to be too big to fail.

But then you found that inflation doesn't inflate everywhere equally. Commodity prices began to soar and worse, the price of oil skyrocketed to all-time record levels.

The spike in oil prices combined with an already slowed economy from the housing bubble dissipation to send the U.S. economy into deep recession. And then, the full forces of deflation were unleashed, most significantly as U.S. automobile manufacturing specifically and industrial production generally took the brunt of the fallout from the public's reaction to record prices at the nation's gas pumps.

Suddenly, tens of thousands of highly skilled workers found themselves out of work, with little prospect of finding any new work that could utilize their long-accumulated skills anytime soon.

Believe it or not, the U.S. jobs situation is far worse for unskilled workers. Thanks to a 41% increase in the federal minimum wage that was incremented in steps from 2007 through 2009, millions of low-wage jobs have disappeared from the U.S. economy, with nearly two million of those lost jobs hitting the least skilled, least educated and least experienced portion of the U.S. workforce: teenagers. Who, by the way, only represent just over 3% of the entire U.S. workforce.

The two together, along with the prolonged expected joblessness, have added additional deflationary pressure to the U.S. economy, as many of these individuals rely upon unemployment benefits (for the skilled workers) while the unskilled workers (mostly teens) rely on their families, who are then harder pressed to make ends meet, cutting back their spending in response.

So if you were the Fed Chairman, and you've previously announced and demonstrated that you have the ability to create inflation in the U.S. economy, or at least could act to lessen the effects of deflation, why might you choose to not act? Especially as the economy is now trending strongly toward deflation with some pretty notable economists screaming out their Keynesian-based fears of the potential impact?

We think the answer lies with the balancing act the Federal Reserve has to perform with the U.S. federal government. Here, since the current majority of politicians in Congress and the President are committing to ever more grandiose government spending projects and power grabs over large segments of the private sector of the U.S. economy, the government is growing increasingly reliant upon borrowing money to fund its operations, as well as to continue extending programs targeted at the jobless, such as unemployment compensation. All without having to cut into any pork-barrel spending that many politicians are counting upon to either get re-elected or to help pad their forced retirement if they lose their elections this November.

To facilitate the government's seemingly insatiable demand for borrowing, U.S. treasuries must be made more attractive with respect to those of other nations as well as other kinds of investments. And one way to do that in the short term is to tolerate a deflationary trend in the U.S. economy, which increases the real yield to investors for U.S. debt.

That it comes at a time when nominal yields for U.S. Treasuries are falling is icing on the cake - that lowers the cost of borrowing for the U.S. government, enabling it to do even more. We've been observing just such a trend since April 2010 and in fact, we think it may be behind the recent upswing in unemployment as the deflationary trend makes it relatively more expensive to hire new employees, especially unskilled teens earning the mandatory federal minimum wage than it did earlier this year. In effect, it's equivalent to a new hike in the minimum wage.

And that's likely why a perceived anti-deflation hawk like the current Fed Chairman might rationally choose to allow deflation, if only for a short time.

Labels: economics