Zero Interest Rates, But Where's the Inflation

Currently deflation is winning the first couple of rounds in the inflation/deflation debate raging among economists, analysts, and investors. CPI/PPI remains subdued. GDP growth is sluggish as evidenced by this morning's GDP report, which showed a slow down in second quarter growth to a 2.4% annualized rate. Wage price inflation? Forget about it. You have to have a job first before you demand higher wages. Commodities surging? Yeah, cocoa prices hit all time highs, mostly due to some jokers at a commodities hedge fund who are clearly trying to build the world's largest chocolate bar, because why else would you take delivery of the biggest amount of physical cocoa in 14 years? But the price of gold hasn't really kept up with the gold bug crowd's expectations. Even hedge fund manager John Paulson has suffered losses in his funds, and he had managed to expertly time every hairpin turn in the market for some time.

So the Fed is keeping interest rates at zero, and anyone who's had any economics classes knows that exceedingly friendly monetary stimulus coupled with exceedingly friendly fiscal stimulus should cause runaway inflation. Except that hasn't happened yet. Instead prices for everything have either taken a breather from heading lower (i.e. housing,) or are still actively going lower (i.e. your favorite retailers are having a sale.)

The only thing staging a monster rally is financial assets. The stock market ripped, and is currently taking a reflective pause to decide if it can defy all the recent rotten economic news to rip ever higher. Heck even the Fed's portfolio of Maiden Lane securities is staging a big comeback. Paper profits on "formerly" toxic securities! But the real out-performer is the bond market. Interest rates on treasuries are at record lows. This was the busiest July on record for sales by junk issuers. Financial firms are jumping on the bandwagon, feverishly issuing debt at record low rates before the window of opportunity closes. According to the FT:

Wall Street executives say recent debt issues were triggered by “reverse inquiries” – informal approaches by fundmanagers seeking to raise their exposure to a sector they had largely avoided since the crisis.

Fund managers have so much cash with nowhere good to go with it, so they're begging financial firms to issue debt. Why financial firms? Because they are too big to fail. So you get slightly higher rates than treasuries, with the US government's stamp of approval on it. What is too much money chasing too few goods? I think that's called inflation.

Seems like the "reverse inquiry" situation was exactly what was going on in the mid-00's, when Wall Street needed subprime product to continue to feed the CDO machine. All the demand for subprime mortgages perpetuated the frenzy in housing. Again CPI/PPI was subdued and interest rates were low because there was no "inflation," just a massive financial bubble in the making. Will the story end the same way this time?