Fed only fools itself if it tries to trick public

If I were a central banker, I would be afraid.

If I were a central banker getting ready to embark on another round of quantitative easing, I would be very afraid.

Here's why. Central bankers in the US are being bombarded with market-based signals suggesting their fears of deflation, or falling economy-wide prices, may be misplaced.

Gold prices continue to set new highs. The US dollar, the global reserve currency, keeps sinking amid expectations the Federal Reserve will dilute the existing stock starting at its November 2 to 3 meeting.

Commodity prices, both industrial and agricultural, are on a tear. The CRB Spot Raw Industrial Price Index, which includes scrap metals, cotton and rubber — but not oil — hit an all-time high last week.

Junk bond issuance already set a record for the year, with demand for high-yield debt narrowing spreads to Treasuries. Investors are pouring money into emerging markets debt issued in local currencies by countries that used to be considered banana republics.

Blowing bubbles

Mexico sold $1 (Dh3.67) billion of 100-year bonds, double the announced issue size, at a yield of 6.1 per cent. Just ask yourself: Would you lend money to Mexico for 100 years? Exactly.

If the Fed's goal was to make investors move out the risk curve, it succeeded. An alternate interpretation: Zero-per cent interest rates are causing a misallocation of capital, a nice way of saying, "asset bubbles."

The markets aren't validating the Federal Reserve's preoccupation with a deflationary spiral. In fact, the message is just the opposite.

And why not? The Fed has told us inflation is below the level it considers consistent with maximum employment and price stability. For the record, various measures of inflation show prices rising anywhere from 0.9 per cent to 1.5 per cent on a year-over-year basis.

As a general rule, if a central bank wants higher inflation, it gets higher inflation, sometimes more than it bargained for. Inflation is a monetary phenomenon — something easy to forget amid the preoccupation with inflation expectations — and the Fed is the proprietor of the US dollar printing press.

After 30 years of price stability, the Fed now wants us to believe that it wants higher inflation (wink-wink, nudge-nudge)?

And that's not all. We're asked to believe the Fed can hit a precise inflation target. (How'd that money supply targeting work out in decades past?)

Maybe the Fed can fool some of the people some of the time, but it can't fool all of the people all of the time. In the process, policy makers may end up fooling themselves that they can create expectations of a little more inflation without delivering a lot of the real thing.