THE PERFECT STORM 97There is actually good empirical evidence to support this
approach, which is why the Fed uses it.
But what if this energy price drop is not just noise? What if
it lasts for years because it’s driven by geopolitical and macro-
economic forces that are not going away anytime soon?
If that’s the case, then the standard Fed approach would
miss the significance of the move and underestimate the im-
pact of the price drop and the deflation that comes with it. In
that case, the Fed might raise interest rates in 2015 — as it has
indicated it will — just as persistent price drops are creating
deflationary expectations and driving the economy into a re-
cession. An interest rates increase on the verge of a recession is
the worst possible medicine. But the Fed’s flawed models may
be setting us up for just such an outcome.
In the long run, lower oil prices are good for consumers
and good for real growth. But in the short run, they are bad for
producers, disastrous for junk bond holders and possibly mis-
leading for Fed policy. The next year could be a rough ride as
the layoffs pile up and the bad debts roll in. It would be even
worse if the Fed misread the tea leaves and raised rates as they
have threatened to do.
You should scour your portfolios and sell any bond funds
that are stuffed with junk debt. Then, use the proceeds to build
cash positions and buy high-quality U.S. Treasury notes. The
cash will preserve wealth, and the notes will produce gains in
the deflationary times ahead. When visibility about Fed policy
improves, the cash can be deployed to buy distressed assets on
the cheap. We’ll have more to say about what those bargains
might be in the months ahead.
■ Spill-Over Effects and Contagion
In 1933, during the depths of the Great Depression, famed
economist Irving Fisher wrote a work that became a classic of