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Bernanke's Worst Nightmare: Rising Real Interest Rates


What seems to be lost in the monetary debate is that this persistent drop in inflation defies the primary purpose of quantitative easing, which is designed to lower real interest rates.

To give you an idea of how serious this development could get, you have to look no further than comments straight from the horse's mouth. (Emphasis mine.)

Deflation is in almost all cases a side effect of a collapse of aggregate demand -- a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers...

When the nominal interest rate has been reduced to zero, the real interest rate paid by borrowers equals the expected rate of deflation, however large that may be… In a period of sufficiently severe deflation, the real cost of borrowing becomes prohibitive. Capital investment, purchases of new homes, and other types of spending decline accordingly, worsening the economic downturn....

Even if debtors are able to refinance their existing obligations at low nominal interest rates, with prices falling they must still repay the principal in dollars of increasing (perhaps rapidly increasing) real value.
-- Ben Bernanke: "Deflation: Making Sure 'It' Doesn't Happen Here," November 21, 2002

Is this not what is happening?

When Bernanke gave his famous "helicopter speech," he probably never dreamed that he was drawing up the exact path of his monetary destiny. You would think the decelerating personal consumption (aggregate demand) and decline in the PCE price index (deflation) with the Fed aggressively trying to engineer the opposite environment would be a frightening development for Bernanke. In fact, it was these exact low inflation rates that scared Bernanke into launching QE II in August 2010. However, the parabolic appreciation of risk asset prices seems to be driving a reassessment of the cost/benefit of QE. It is becoming apparent that regardless of economic conditions, the Fed now views the risks of market disequilibrium as outweighing the reward of further quantitative easing.

In framing the deflationary risks, Bernanke was clearly focused on real interest rates, which were no doubt the focus of the QE program after the financial crisis. Between 2009 and the end of QE II in 2011, the real 10-year yield (using PCE deflator) fell 550 bps from 4.50% to -1.0% as nominal yields fell 150bps and inflation rose 400bps. This negative interest rate regime no doubt helped ease financial conditions, providing a favorable environment for asset price appreciation -- however, it was not without a cost.

In 2011, with the QE reflation trade in full force, top line nominal growth remained subdued and the escalating inflation pressure began to take their toll on the consumer. This was clearly evident in commodity prices and reflective in the performance of gold, the most sensitive asset to negative interest rates. During QE I and II, gold appreciated by 190% in value from $680 in late 2008 to a high of $1920 in 2011, equal to an astounding 44% annualized rate.

Gold vs. Real 10-Year (inverted)

When the Fed opted to terminate QE II at the end of June 2011 due to inflationary pressures, the market was forced to unwind the asset reflation trade that had defined the negative real interest rate regime. Essentially the benefits of negative real interest rates in the financial economy through inflation met the limit of aggregate demand of the real economy. This QE crash kicked off a structural shift that removed the Fed's ability to influence real interest rates. A month later, the real 10-year yield troughed -- and not coincidentally, the price of gold peaked.

In spite of the Fed's uber-easy monetary policy, real interest rates have tightened 200bps since the 2011 low with most of the adjustment being the result of falling inflation. This is the aggregate demand side of the equation, tightening monetary policy in an attempt to normalize real interest rates. This is where Bernanke's deflationary death spiral -- ignited by rising real interest rates -- comes into play. Once the deflationary trend is firmly in place, the real price of money becomes more reflective of the deflation rate and less sensitive to the nominal interest rate.

The inflation trend is clearly lower; this week's PCE deflator is likely going to confirm this trend. The Fed has recently brushed off this deflationary trend as "transitory," attributing much of the decline to falling gas prices. However, upon further inspection, this interpretation seems misguided. The current AAA year-to-date daily average price for unleaded gas is $3.54/gallon with PCE inflation running at 1.0%, which is higher than the $3.48 average price over the same period in 2011 when the oppressive PCE was above 2.0%.

PCE vs. Gasoline

PCE vs. PCE deflator

The fact of the matter is that falling inflation is 100% consistent with falling aggregate demand, which is exactly the condition that Bernanke cited as a deflationary trap in his infamous helicopter speech in 2002. (Emphasis mine/)

However, a principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition. As I will discuss, a central bank… retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero.

Though he wouldn't admit it, Bernanke met his match in 2011. The consumer balked at attempts to stimulate aggregate demand via inflationary policy of negative real interest rates, and ever since, has been raising real interest rates by reducing inflation through lower aggregate demand. This is perhaps the most unappreciated yet significant market development since the financial crisis.
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