Jeremy Siegel on 2010: Good for Stocks, Bad for Bonds -- and Why Interest Rates Will Go Up - Knowledge@Wharton

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Understanding the rules for 2010. Interview by Knowledge@Wharton of Wharton Professor Jeremy Siegel.

Jeremy Siegel on 2010: Good for Stocks, Bad for Bonds -- and Why Interest Rates Will Go Up - Knowledge@Wharton


Knowledge@Wharton: What is inflation going to do?

Siegel: Inflation is going to be under control this year and probably into 2011. However, we will have an upward tilt to inflation, which means the longer-run trends point to a 2%-to-4% range of inflation rather than zero to two, which unofficially is what most central banks and the Fed have targeted.

The scaremongers, who worry that the ton of money the Fed created to fight off the crisis is going to fuel the next [period of] inflation, are wrong.

Knowledge@Wharton: But the 2%-to-4% range is standard over the long run, right?

Siegel: It's not. I remember when I was studying economics, we talked about what a victory it would be if we could get down to between 2% and 4%. We've been spoiled with very low rates. Most central banks use zero to two. They come closer to two.

We'll move closer to between 2% and 4%, particularly in the United States, given the large deficits that we have and the liquidity that was created. But just as Bernanke acted very responsibly in providing the liquidity necessary to prevent [a repeat of] the Great Depression, he is also an excellent enough economist to know that money is what fuels inflation. The Fed is really solely responsible for inflation. He will not let it go above five, and probably not even four. He will raise interest rates to whatever level is necessary if inflation starts running into the mid-single digits or higher.

Knowledge@Wharton: When we talk about inflation, we also often talk about commodities. There has been a pretty good run in some commodities, especially gold. What do you see happening there?

Siegel: The commodities cycle has followed the world economy. It had hit its low very close to the same time the stock market did. Now that the world markets have recovered, we see oil has recovered. I would love to see it in the 70-to-80 range.

Commodities are fully priced. Gold ... is priced for an inflationary scenario that is much worse than will be realized. Gold is a risky investment now.... That is not going to be a good investment throughout 2010 and the longer term.

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The Slide Continues

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Bloomberg.com: Worldwide: "The U.S. economy is likely to keep deteriorating in early 2009 after shrinking last quarter by the most since 1982, as consumers and businesses retrench.

The 3.8 percent annual pace of contraction in the fourth quarter was less than forecast, with a buildup of unsold goods cushioning the blow. Excluding inventories, the decline was 5.1 percent, the Commerce Department said yesterday in Washington.

Job cuts announced this month by companies from Starbucks Corp. and Pep Boys - Manny, Moe & Jack to Eastman Kodak Co. mean there’ll be little respite in the first half of this year, economists said. The Obama administration used the figures to reinforce its call for Congress to pass a stimulus package in excess of $800 billion to arrest the economy’s decline.

“The recession is going to last through most of 2009, and we’ll be lucky to have growth back at zero by the end of the year,” Kenneth Rogoff, a Harvard University economics professor, said in a Bloomberg Television interview from Davos, Switzerland, yesterday. Economic growth “will be pretty tepid for a long time.”"

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Is Deflation a Risk in 2009?

According to the Barclays Capital Weekly Economic Monitor, there "is little immediate risk of deflation."
The report goes on to say that although headline inflation will fall into negative territory (yr to yr) heading into fall 2009, this is primarily due to falling in energy prices. Once energy prices "find a bottom, inflation will naturally rise back to the level of core inflation. This is a case of a big fall in one relative price, not a broad-based deflation."

The report goes on to say that the real risk of deflation comes in 2010. If the unemployment rate does not come down quickly from the presumed 8% peak, core inflation will drop steadily and could pierce the lower end of the 1-2% Bernanke bands in 2010. This risk argues for continued very accommodative monetary policy for a long time to come. Presumably, the Fed will want to exit from its aggressive market interventions as quickly as the capital markets safely allow. These programs distort the capital markets, put tax dollars at risk, and should be phased out as soon as it is safe.

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