Fed Gets its Final Data Point: Not Looking so Good

Scant growth figures behind the core consumer price index (excluding food and gasoline) released today could place overall, all-in inflation figures into the negative territory, after including falling prices at the pump.

The Fed's problems with stagnant prices and low inflation is only going to get worse. Today's CPI release showed the index falling 0.1% in August from July, placing it a meager 0.2% above its year-ago level. While much of the weakness was driven by gas prices, this wasn't entirely the problem.

Core prices, which exclude food and energy, rose by only 0.1% from July, placing them up for the year by a rather measly 1.8%. Now, the Fed emphasizes core prices, although it uses a different measure. With this measure core inflation has been showing even weaker growth. Not to mention, the weak headline CPI growth over last year certainly doesn't help the Fed's case on raising rates by the end of its two-day meeting Thursday.

According to the Wall Street Journal, average US gas prices (price per gallon) have dropped from roughly $3.40/gal at the start of 2013 to a current level of just shy of $2.50/gal, representing a drop of 90 cents or so (or a decline in the 26-27% range). 

According to the Energy Information Administration (EIA), regular gasoline prices averaged $2.38/gal Monday, which was 30% lower relative to its September 2014 average at ~$3.41.

And headline inflation appears bound to go even lower. With back of the envelope calculations, if all other items in the CPI rise at September's (slow) rate for the remainder of the year, by year-end the CPI will be running down 0.1% YoY, a far cry from the Fed's 2.0% target.

Excluding food and gasoline, other items purchased domestically should continue to fall in price as cheap imports replace higher-cost goods produced domestically, a result of divergent central bank policies. Domestic producers must pay for labor and other inputs in the (strengthening) US dollar, whereas goods of comparable quality can be produced abroad with cheap currency where central banks are taking devaluation measures and starting currency wars in their battle to remain competitive amidst a challenging global demand environment. Simultaneously, virtually all other commodity prices are falling as well, making raw materials and ultimately finished goods even cheaper.

Bloomberg's Commodity Price Index Hits 16 Year Low (1999 Levels)

As illustrated in the image above, today's commodity price index level calculated by Bloomberg is hovering right around the level it was during the midst of the latest financial crisis in 2008/2009 (around the ~$39 level). With cheap commodity inputs, goods can be produced with even greater cost efficiency, enabling producers to turn a profit while still dropping prices to the end consumer.

With falling import and commodity prices flowing through to consumer price levels, the CPI may head further into negative territory. So, if the Fed holds off on a rate hike after the close of its two-day meeting this Thursday, it may be waiting to October or December at which point it may be considering rate hikes in the context of headline CPI deflation. In short, if the argument for tightening is tough now, it's only going to get worse.

Inflation aside, other global issues should be weighing on the Fed in its policy considerations. 

The most threatening issue, in my view, is the massive amounts of dollar-denominated debt held by non-financial borrowers in struggling emerging markets. We're likely to see some major defaults from EM borrowers who were happy to take on loads of USD-denominated debt when it was cheap (i.e. as it rolled off the Greenspan/Bernanke printing press), but now factors are moving in the opposite direction. Their currency values (in emerging markets) and thus the value of their goods are declining whilst the US dollar is strengthening. Add to this weakening global demand, particularly due to slowing demand from China, and many emerging market borrowers are in real trouble. So how will this affect us and the Fed? Well, who lent all the dollar-denominated debt? Domestic lenders could find themselves empty-handed, facing a real, global credit implosion. As an example, Chinese non-performing loans rose 50% in value between the first half of the year and where they're tracking now in 2H. Brazil, Africa, and other emerging countries face similar solvency issues.

Of course, an implosion in the global credit markets would drive deleveraging across the board, with plenty of spillage into the equity markets.

Simply put, it's ugly out there. The macro backdrop is looking worse than we've seen in many years, and many have yet to take notice.

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