The Fed's great something-flation debate

chart_ws_bond_10yearyield.top(7).pngThe fact that the yield on the 10-year Treasury is below 3% is a sign that investors are not concerned about inflation. Click the chart for more bond and interest rates. By Paul R. La Monica, editor at large


NEW YORK (CNNMoney.com) -- With the economic recovery starting to lose steam, the Federal Reserve has the unenviable task of trying to figure out which "flation" battle to fight. Inflation or deflation?

The Fed will hopefully provide more clues following its policy meeting Tuesday. It's all but certain the central bank will once again leave its benchmark federal funds rate in a range of 0 to 0.25% - the range it has maintained since December 2008.

paul_lamonica_morning_buzz2.jpg

What's not as clear, however, is what the Fed might say about the economy and what it plans to do to combat its slowing momentum.

The Fed's official party line for months has been that inflation is not a concern. In the statement following its last meeting in June, the Fed reiterated that longer-term inflation expectations are "stable" and that "inflation is likely to be subdued for some time."

But according to the minutes of that meeting, "a few participants cited some risk of deflation." That's the risk that prices fall at a persistent rate, which tends to lead to reduced business production, higher unemployment and lower wages.

St. Louis Federal Reserve president James Bullard, who is currently a member of the Fed's policy-setting committee, wrote a paper last month warning that the probability has increased for a "Japanese-style deflationary outcome for the U.S. within the next several years" if the Fed did not start buying more Treasurys again.

Despite the rising deflation fears, economists said the chances of the Fed dropping a D-bomb in Tuesday's statement are highly unlikely.

"If I were in Las Vegas, I'd have to get some pretty big odds to bet that the D word would be in the statement," said Terry Clower, director of the Center for Economic Development and Research at the University of North Texas.

Clower said investors are already spooked by deflation worries. Mentioning deflation could be self-defeating since the Fed could cause more deflationary pressure if it said something that sent stock prices and long-term bond yields tumbling.

"It would be unusual for the Fed to put that kind of fear in the market. It almost could be a self-fulfilling prophecy," he said.

Clower said deflation seems to be a popular economic buzzword of late, but he does not think it's the Fed's biggest problem.

John Stoltzfus, senior market strategist with Ticonderoga Securities in New York, agreed. He said the Fed, along with other central banks such as the European Central Bank, appear to be doing a good job of acting in tandem to ensure that the global recovery remains on track. The ECB held rates steady at 1% Thursday.

Stoltzfus added that it's hard to imagine a deflation problem as long as China's economy is growing as rapidly as it is.

"The concerted efforts of central banks and demand from emerging markets - where there are inflation risks - do offset deflation fears," he said.

With that in mind, some believe the Fed should spend less time worrying about short-term deflation scares and more about the potential for longer-term inflation problems.

The Fed did indicate in the minutes of the June meeting that "a few participants noted the possibility that a potentially unsustainable fiscal position and the size of the Federal Reserve's balance sheet could boost inflation expectations and actual inflation over time."

That's problematic. The possibility of prices rising before the job market and housing markets rebound raises the specter of stagflation, the combination of a weak economy and high prices, particularly for commodities such as oil. The U.S. briefly flirted with a period of stagflation in the summer of 2008 when the economy was rapidly slowing and gas prices were at record highs.

But some economists have even worse fears. Because the Fed has essentially turned on the printing press to try and stimulate the U.S. out of the economic morass, those economists believe the ultimate cost will be a worthless dollar and runaway inflation or hyperinflation.

Those concerns are likely overblown. Keith Hembre, chief economist for First American Funds in Minneapolis, said the combination of tight credit conditions and an anemic jobs market gives the Fed leeway to sit tight and not make any significant changes to its policy anytime soon.

"I suspect the Fed will continue to say inflation remains subdued," he said. "Even with the Fed's balance sheet expansion, there is no inflation threat for the foreseeable future and there won't be for several quarters.

That's probably true. But it would be a mistake for the Fed to ignore the possibility of inflation at some point down the road.

"When the economy finally turns the corner for good, you could certainly see pricing pressures. There is a scenario where inflation could be an issue. It's not evident now, but it's more likely than deflation," Clower said.

- The opinions expressed in this commentary are solely those of Paul R. La Monica. Other than Time Warner, the parent of CNNMoney.com, La Monica does not own positions in any individual stocks.  To top of page

Frontline troops push for solar energy
The U.S. Marines are testing renewable energy technologies like solar to reduce costs and casualties associated with fossil fuels. Play
25 Best Places to find rich singles
Looking for Mr. or Ms. Moneybags? Hunt down the perfect mate in these wealthy cities, which are brimming with unattached professionals. More
Fun festivals: Twins to mustard to pirates!
You'll see double in Twinsburg, Ohio, and Ketchup lovers should beware in Middleton, WI. Here's some of the best and strangest town festivals. Play
Overnight Avg Rate Latest Change Last Week
30 yr fixed4.19%4.26%
15 yr fixed3.23%3.27%
5/1 ARM3.34%3.45%
30 yr refi4.17%4.23%
15 yr refi3.21%3.25%
Rate data provided
by Bankrate.com
View rates in your area
 
Find personalized rates:
Index Last Change % Change
Dow 17,007.32 24.73 0.15%
Nasdaq 4,460.10 15.19 0.34%
S&P 500 1,980.46 1.55 0.08%
Treasuries 2.47 -0.02 -0.72%
Data as of 1:22pm ET
Company Price Change % Change
Frontier Communicati... 6.75 0.81 13.64%
Windstream Holdings ... 11.95 1.42 13.49%
AT&T Inc 36.69 1.04 2.93%
CenturyLink Inc 39.75 2.04 5.41%
Apple Inc 98.58 -0.44 -0.44%
Data as of 1:08pm ET

Sections

In push for protein, fast-food chain offers Mega Meat Stacks that are twice as large as regular sandwiches. More

New annual report from U.S. government shows the long-term prognosis for Medicare has improved thanks to slower health spending, while the outlook for Social Security remains unchanged. More

Bunch o Balloons allows multiple water balloons to be filled at once. Parents are loving it -- to the tune of $645,000. More

Steve Mason, a pastor from California, inherited more than $100,000 in student loan debt when his 27-year-old daughter died suddenly in 2009. With interest and late penalties, the debt has since ballooned to $200,000. More

Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.