In October, the Consumer Price Index (CPI) fell 1.0%, its largest decline ever (since the stats started being kept in 1947), although prices are still 3.7% higher than a year ago. Inflation is, like, so last summer, as an economic concern.

The decline in prices was led by a 8.6% decline in energy costs, which follows declines of 1.9% in September and 3.1% in August. Food prices rose just 0.3%, but are still up 6.1% year over year.

In addition to energy, prices also fell for apparel (retailers desperate to get customers in the door) and prices for both new and used autos also fell. But even stripping out food and energy prices, the core CPI fell 0.1%.

Under normal conditions, this would be a huge green light for the Fed to cut the Fed funds rate. However, these are not normal conditions. The Fed funds official target rate is just 1.0%, and even that overstates things since the effective Fed funds rate is just 0.37%. Thus, even if the Fed were to cut by another 50 basis points in December, it would still be behind the curve with the market. On the official target rate, there are just four 25 basis-point bullets left in the gun, and it is not clear just how effective those bullets would be.

The velocity of money is slowing like it never has before, or at least since the 1930's. "Velocity" is the technical term for people just sitting on their wallets and banks just stuffing every spare dollar into 3-month T-bills. This is very important since nominal GDP is equal to the amount of money in circulation times the velocity of that money.
Falling prices are one symptom of declining velocity, which is not offset by higher money supply -- falling output is the other symptom.? The yield on the 3-month bill is back down to a measly 4 basis points, almost as bad as the worst point of the September credit crunch. This is the moral equivalent of a bank simply putting every last dollar it has into the vault, closing it up and setting the time lock on it for 2009. The Fed desperately needs to ease monetary policy, but its key tool for doing so is at a point where it will no longer work very well. The Fed is now at the point where it is pushing on a string. What are the Fed's options??

1) It could try to convince the markets that short-term rates will stay low for longer than the market currently expects. This would bring down longer-term rates which would help stimulate the economy. I'm not really sure how credible that the Fed can be in doing this.
?
2) It can change the composition of the Fed balance sheet. Under normal conditions the Fed holds Treasury securities across the whole maturity spectrum, but heavily weighted towards the short-end of the curve (the average maturity is usually well under four years). However, the Fed has already lent out most of its Treasury securities under its various alphabet soup liquidity programs.? The collateral the Fed currently holds is probably of lower quality than that of your average pawn shop on the wrong side of the tracks.?

Still, selling short-term bills and buying longer-term bonds would help bring down longer-term yields, at least for Treasury securites. However, several key market rates have disconnected themselves from Treasury rates of the same maturity (i.e. spreads have widened dramatically), so such a policy might not have that much economic impact.
?
3) The Fed could simply continue to increase the size of its balance sheet by outright buying longer-term T-notes on the open market. In the process, it causes the banks to replace interest-bearing T-notes for non-interest-bearing reserves, which the banks can thus lend out. This is the functional equivelent of "turning on the printing presses." This is a direct attempt to cause inflation to offset the deflation. The size of the Fed Balance sheet has already been ballooning, having more than doubled since mid-September.?

In other words, it looks like the Fed has been trying to do the right things, but it still is not working.? The massive increase in the money supply that is implied by the huge expansion of the balance sheet does carry dangers. Monetary policy tends to work with very long lags, and the data the Fed has to work with is far from perfect. There is a real danger of an overshoot, which could cause very significant inflation, even to the point of hyperinflation down the road. This is not a path that central bankers like to go down, but at this point it looks like they have little choice.

Given the likely ineffectiveness of monetary policy at this point, I would continue to avoid stocks like JP Morgan Chase (JPM) and Citigroup (C).