Market Talk

They used to be 45 cents, you know.

We’ve mentioned deflation once or twice, and that it’s the Fed’s worst nightmare. It’s the boogieman, the Headless Horseman, the Candyman (the scary one, not Willy Wonka*,) don’t dare speak its name, because to speak its name is to give it life, and once it comes, there’s hell to pay.

Ever notice how badly the Fed contorts its words to avoid saying deflation? Check out this chestnut from the minutes of the September FOMC meeting:

…the expected policy path shifted down further, on net, as investors apparently interpreted weak labor market conditions and generally quiescent inflation as consistent with an outlook that would lead the FOMC to maintain low policy rates over the medium term.

The Fed has pumped more money into the system than ever in its history, combined (the image of a fire hose often comes to mind,) and inflation is “generally quiescent?” Dropping interest rates to zero and keeping them there is absolutely unprecedented in the Fed’s history. Inflation should be out of control at this point (and measured the right way, by, say, stock or commodity prices, it is.) But it isn’t. It isn’t, and if it isn’t, it has to be because there is a large counterweight somewhere.

This is total speculation on my part, but looking at what the Fed’s doing, rather than what they’re saying, I’d say they’re terrified of deflation. And deflation’s in the air because of what is still a very weak labor market, much weaker than the stock market is accounting for.

Today’s report on productivity and labor costs offers another window in that specter of which central banks dare not speak. Productivity in the third quarter jumped by the most in six years. But it did so on the back of a huge drop in unit labor costs, as employers kept firing employees. And therein lies the danger, as Capital Economics’ Paul Ashworth writes:

That rate of annual decline in unit labor costs is the most severe in at least the last 40 years. Let’s be clear, labor is by far the biggest input into production, not just in the service sector but in manufacturing as well. Forget the rise in the oil price to $80 a barrel, it’s a sideshow compared with the collapse in labor costs. We don’t see firms padding their margins with these cost savings, not with demand as shaky as it is. These savings will feed through into lower final prices. The upshot is that deflation is still by far the biggest threat.

Jobless claims took another dive this morning, to their lowest level since Jan. 3, and tomorrow’s jobs report should (hopefully) ease to under 200,000. Now, that’s still a bad number, but compared to the nearly 700,000 we were losing, it looks great.

During the 2001 recession, there were only five months where monthly job losses were over 150,000; tomorrow’s report will represent the 15th consecutive month above that level. More importantly, companies are not hiring. Yesterday’s ISM services report showed that. “The percentage of companies adding workers fell from 13% in September to a record-low 5% in October, matching the low reached last November,” MarketWatch’s Rex Nutting wrote.

Jobs aren’t being created, wages aren’t rising, people aren’t spending. This is a big, very big counterweight to the inflation that the Fed is consciously stoking. In the abstract, inflation is not a good thing, but in this particular case, it actually is good, in a way, because when it finally shows up it will at least reflect increasing economic activity.

The Fed better hope it gets inflation, because if it doesn’t, it may get that other thing, the thing no central banker dares speak of.

(*Actually, Newswires editor Sam Favate has long said that “Willy Wonka” is the scariest movie ever made. It’s got quite a body count, when you think about it. All they’re all little kids.)