Quote from zf trader:
What happens if we have a large drop in the price of oil at the same time that the fed hike rates up to 5%? Deflation is still lurking in many sectors of the economy but since we don't have any 120 year old economists at the fed who remember the 1930's it is not considered with the same enthusiasm as inflation. Of course all policy makers remember 21% prime in Canada (17%?? in the states) and will make sure that it does not happen again.
Where would prices be if we didn't hit the "tipping point" that caused commodities to rise in price at the same time China started to become the world's workshop? The free movement of capital and labour gives the world an underlying productivity that is deflationary in the long run.
This keeps me up at night too.
But it seems that the TPTB won't permit that, so expect any sort of silly fiscal policy that is inflationary or increase in money supply to avoid that situation.
Bernake's 'helicopter speech' pretty much seals the deal for me.
While I haven't really fleshed this idea out fully, my gut feel is that we have narrowly missed depression ][ - the sequelae of the internet bubble popping, the slowdown of 9/11, and the deflationary effects of China and the resultant labor arbitrage scenario that is happening now.
The presence of real deflation in the setting of 1% interest rates would have been quite a blow to the economy, and the resulting asset deflation in the equity market would have been carnage. Furthermore, it would have a disaster to our boomer generation who are about to retire, probably forcing many of them to retire in poverty. The resulting banking crisis would probably erase much of the percieved wealth of the US and take us about 5-10 years until we got back on our feet (like the Japanese). That would give China a 5-10 year head start on us, which would really be a disaster. Not a very palatable situation.
So instead, RE bubble allows for equity refinancing that allows people to tap home equity lines and spend $$ for a recovery. Economy keeps plugging along, fed raises rates to allow for next round of easing, oil prices rise to create manufactured inflation and a necessary slowdown to catch up with debts. Long term rates rise & equity markets don't crash (too much) which keeps the asset markets going and everyone is happy.
Simple no? Except there's that damn conundrum....
