Deflationary Rate Hike?

Deflationary Rate Hike?
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In the aftermath of Ben Bernanke's announced timetable for ending Fed bond purchases, long-term interest rates have jumped up while stock prices have cratered down. As I wrote yesterday ("Bernanke Jumps the Gun"), I think the Bernanke plan is premature -- especially in a 2 percent economy with falling inflation and inflation expectations.

But just to get a little wonky on the interest-rate story, it's noteworthy that 10-year Treasury notes have moved up about 70 basis points year to date. Currently they're around 2.50 percent.

Most of that rate rise -- more than 50 basis points -- is coming from a jump in Treasury inflation-protected securities, known as TIPS. Now that could be a good thing, as rising real interest rates signify a stronger economy.

The trouble is, on balance, it's real hard to find strong evidence of a stronger economy. Instead, as economist David Goldman has noted, investors are bailing out of TIPS because they're not worried about inflation -- which, by the way, is running about 1 percent.

So selling TIPS bonds has raised market interest rates. And that, in turn, has done considerable damage to the stock market and perhaps will pinch the economy.

But the story doesn't end there. So called inflation break-even spreads have been narrowing significantly. This includes 10-year TIPS implied inflation, as well as 5-yr 5-yr forward inflation expectations. They've all dropped about 60 basis points, which is roughly equal to the rise in real interest rates.

So one could argue -- as a warning to Mr. Bernanke -- that rising rates is a deflationary event, not a growth event. And if the Fed is too hasty in tapering its bond purchases -- and after all, tapering is really tightening -- interest rates may continue to rise for the wrong reasons, namely deflation rather than faster economic growth.

There is no doubt that the Fed has got to end its bond purchases and eventually figure a way out of its oversized bond portfolio. In recent months I have commended Mr. Bernanke for producing low inflation, after many of us wrongly predicted higher inflation. But as St. Louis Fed head James Bullard said this morning, the low-inflation trend may be too much of a good thing. And bond-purchase tapering -- excuse me, I mean tightening -- could generate deflationary impulses that could damage the economy.

As an old gold-watching guy, I am obliged to note that the crash in the gold price is moving side by side with the decline in inflation expectations.

All this is why I believe the Fed should move extremely slowly in shifting policy in our still fragile economy.

Larry Kudlow is a senior contributor at CNBC, and also co-author with Brian Domitrovic of the new book JFK and the Reagan Revolution: A Secret History of American Prosperity.  

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