A very interesting posting by Ray Dalio, Chairman and Chief Investment Officer at Bridgewater Associates, L.P. a hedge fund that manages $169 billion in global investments looks at what lies ahead for the Federal Reserve, now that global stock markets have shown a great deal of volatility. With the Fed telegraphing that it would consider lifting-off interest rates sometime during the late third and early fourth quarter, the recent volatility in both commodities and stocks must be giving the world's most influential central bankers reason to ponder their decisions to both taper and lift-off.
In the minutes from the July 28 - 29, 2015 FOMC meeting, there are repeated references to inflationary pressures falling below the 2 percent threshold as we can see in these quotes:
"Inflation had continued to run below the Committee’s longer-run objective, but members expected it to rise gradually to- ward 2 percent over the medium term as the labor mar- ket improved further and the transitory effects of earlier declines in energy and import prices dissipated."
"However, core inflation on a year-over-year basis also was still below 2 percent. Moreover, some members continued to see downside risks to inflation from the possibility of further dollar appreciation and declines in commodity prices."
Keeping in mind that oil prices have done this over the past 12 months:
...and that commodities as a whole have done this over the past 12 months:
...the Fed's concerns about low inflation/deflation are definitely not unfounded.
Now, let's get back to Mr. Dalio's musings. He begins by explaining the interaction between short-term interest rates and the returns of other longer-term asset classes. He notes that central banks want interest rates to be lower than the returns that investors can gain by borrowing money to purchase longer-term investments. He notes that if short-term interest rates were always lower than the returns of other asset classes, everyone would run out and borrow cash to own higher returning assets. Central banks can step in to control this process by raising interest rates when the growth in demand for assets outstrips the capacity to satisfy the demand, thereby controlling inflation and economic growth levels. On the other hand, declines in interest rates cause asset prices to rise, largely because the lower interest rates reduce the discount rate that future cash flows are discounted at, raising the net present value of the assets.
He goes on to state the following:
"…since 1981, every cyclical peak and every cyclical low in interest rates was lower than the one before it until short-term interest rates hit 0%, at which time credit growth couldn't be increased by lowering interest rates so central banks printed money and bought bonds, leading the sellers of those bonds to use the cash they received to buy assets that had higher expected returns, which drove those asset prices up and drove their expected returns down to levels that left the spreads relatively low.
That's where we find ourselves now—i.e., interest rates around the world are at or near 0%, spreads are relatively narrow (because asset prices have been pushed up) and debt levels are high. As a result, the ability of central banks to ease is limited, at a time when the risks are more on the downside than the upside and most people have a dangerous long bias. Said differently, the risks of the world being at or near the end of its long-term debt cycle are significant." (my bold)
He concludes by noting that the "...risks of deflationary contractions are increasing relative to the risks of inflationary expansion..." and that the Fed has boxed itself into a policy corner because it has spent a great deal of time advertising the notion that it will begin to tighten at a time when they should be telegraphing that they continue their current monetary policies. The title of Mr. Dalio's posting says it all "Why We Believe That the Next Big Fed Move Will Be to Ease (via QE) Rather Than to Tighten".
Only time will tell whether global economic developments will force the Federal Reserve to add to its already bloated $4.487 trillion balance sheet to avoid the spectre of deflation, further pushing its monetary experiment into uncharted territory.