U.S. regulators raise the spectre of deflation.

This month's decision by the U.S. Federal Reserve Board to hold the line on interest rates was a big contributor to the surge in the value of our loonie. It wasn’t the Fed’s stand-pat stance that prompted the jump of a full cent in the value of our dollar in a single day. It was the Board’s outlook for the coming months that raised eyebrows and sent the U.S. greenback on a tumble.

Most people have never actually read a Fed policy statement. From all the media hype they engender, you might think that these are long, ponderous documents. In fact, they are usually quite short. Last Tuesday’s announcement, for example, is only four paragraphs long, and one of those paragraphs consists mainly of listing the names of Board members.

Although the policy statements are short, they are sometimes difficult to understand at first glance, couched in a form of Fedspeak that requires translation so that the general public can grasp what is really being said.

Take the two key paragraphs from the latest announcement, for example. They state as follows:

“Recent readings on production and employment, though mostly reflecting decisions made before the conclusion of hostilities, have proven disappointing. However, the ebbing of geopolitical tensions has rolled back oil prices, bolstered consumer confidence, and strengthened debt and equity markets. These developments, along with the accommodative stance of monetary policy and ongoing growth in productivity, should foster an improving economic climate over time.

“Although the timing and extent of that improvement remain uncertain, the Committee perceives that over the next few quarters the upside and downside risks to the attainment of sustainable growth are roughly equal. In contrast, over the same period, the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level. The Committee believes that, taken together, the balance of risks to achieving its goals is weighted toward weakness over the foreseeable future.”

What exactly are we to understand from this? Long-term, the Fed members believe the economy will improve. However, long-term, we’ll all be dead. Take a look at the line that reads: “. . .the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level.” This is critical to understanding where the Fed is positioning itself right now. The statement never uses the word “deflation” but that is the danger that is being warned of here. Some economists have already pooh-poohed the idea. The Fed says the risk is “minor”, but we shouldn’t be too quick to dismiss it out of hand. In the next sentence, the members state that the balance of risk is “weighted toward weakness over the foreseeable future.”

This stance has significant implications for investors that only the brave (or the foolhardy) should ignore. They include:

1)A further reduction in U.S. interest rates as the summer unfolds, which could have the effect of pushing the loonie even higher.

2)A negative impact on U.S. real estate values, if prices generally start to decline. The real estate sector has been one of the few to show any strength in recent years.

3)A growing profit squeeze for corporations. If even mild deflation takes hold, it will be very difficult to raise prices and some companies may actually have to cut them or offer greater cash incentives to buyers to stay competitive. This, in turn, would put pressure on share prices.

4)Although the Bank of Canada is worried about inflation, that risk will decline dramatically if U.S. inflation falls sharply or goes into reverse. That would likely force a change in monetary policy in this country.

What should you do about all this? Here are some suggestions:

Remain cautious about stocks. There appears be a disconnect between the Fed’s warning and the performance of the major U.S. stock indexes in recent weeks. Although there are some good opportunities in the market, overall stock prices look vulnerable and a pull-back from recent gains is a good possibility.

Emphasize Canadian securities. The rise of the loonie and the fall of the U.S. dollar has produced windfall profits for anyone holding Canadian securities, whether equities or income-generating assets. That pattern could continue for the next few months.

Maintain bond positions. We’ve heard repeatedly in the past two years that bonds have had their run and now represent a greater risk than stocks. Here at the IWB, we’ve consistently urged members to ignore those warnings and to maintain a balanced portfolio with strong bond positions. In a deflationary environment, only a few types of securities hold their value and have profit potential. One of them is high-grade government bonds.