Yield Sign Suddenly in Fed’s Way (Low Inflation Is Exacerbating the Problems From Slowing Global Growth)

By: Justin Lahart

Oct. 14, 2014 5:37 p.m. ET

The prospect of slowing global economic growth is worrisome enough for U.S. investors. That it comes at a time when inflation around the world is low, and central banks have little firepower, is what makes it really unsettling.

Prices around the world have taken a chill. With producers of oil and other raw materials geared for breakneck Chinese growth that is no longer a given, these markets have taken a hit. Brent crude oil slumped 4.3% on Tuesday to its lowest level since 2010. Commodities ranging from corn to copper are also near four-year lows.

Reflecting unease, Treasury yields have tumbled, confounding expectations they would move higher as the Federal Reserve ended its bond-buying program this month. The yield on the 10-year note fell to 2.206%, Tuesday, its lowest level in over a year.

Meanwhile, numbers released Tuesday showed that consumer prices were up just 1.2% in September in the U.K. from a year earlier, up 0.3% in France and down 0.2% in Spain. Even inflation-prone India’s wholesale price index advanced last month at its slowest annual pace in five years.

Falling commodity and overseas prices, along with the dollar’s recent strength, will put downward pressure on already-low inflation in the U.S. By the Fed’s preferred measure, consumer prices were up just 1.5% from their year-earlier level in August. That is far short of the 2% rate the central bank is aiming for. While too much inflation is a bad thing, so is too little, as it opens the risk of a general fall in prices, such as what Japan has experienced.

In normal times, when the underlying trend in U.S. inflation was higher, the Fed could afford to look through the effect on prices of a slowdown overseas as largely transitory. That is especially the case when, as now, hiring is picking up and the economy looks as if it is gaining strength.

But what is happening to prices globally now isn’t so easy to ignore. If U.S. inflation was to cool to, say, less than 1%, and the economy was then hit with some sort of shock, the Fed could soon have a deflationary environment to deal with. And it could again have to resort to bond buying and other unconventional measures in a bid to get the economy going.

If an improving U.S. economy had the Fed considering raising rates earlier than the mid-2015 date markets have settled on, it isn’t anymore. Indeed, over the weekend Fed Vice Chairman Stanley Fischer said that weaker overseas growth could lead the Fed to move “more slowly than otherwise.”

For other central bankers, the problem of low prices is more immediate. Both inflation and growth are lower in the eurozone than in the U.S., raising the risk that the region faces years of stagnant growth. Yet the European Central Bank’s ability to act has been constrained by German resistance to additional easing and a brewing fight over France’s attempt to breach European Union fiscal rules.

In China, where consumer prices are running well below Beijing’s target for the year of a 3.5% increase, low inflation is symptomatic of consumer demand that isn’t strong enough to drive economic growth at anywhere near the pace the government sees as necessary. But policy makers there worry that easing credit conditions in a bid to boost the economy could also reflate potential bubbles in assets such as property.

Meanwhile, recent economic data out of Japan have been at odds with the Bank of Japan’s bullish assessment. And the buckling of commodities prices has put the economies of resource-exporting countries such as Australia at risk.

The danger is that the global slowdown could be more than just temporary, and the world’s economic trajectory has been lowered. Even if the U.S. economy somehow proved an exception, this would still be a major problem for the many U.S. companies that generate a large portion of their sales overseas. And with global inflation heading lower, the U.S. might not prove an exception for long.

The Fed has long said that its policy is squarely focused on what’s happening at home rather than what’s happening overseas. But with weakness abroad threatening to cut into a U.S. economy that has only recently found its footing, it may need to change that calculus.

Write to Justin Lahart at justin.lahart@wsj.com

Leave a Reply

Your email address will not be published. Required fields are marked *