Konichiwa, Ben Bernanke

As markets work through the dog days of summer, there appears to be a growing debate on the FOMC between the doves worried about Japan-style deflation, represented by James Bullard of the St. Louis Fed, and hawks worried about keeping rates low for too long, represented by Thomas Hoenig of the Kansas City Fed. Chairman Bernanke's flag is firmly planted in the Bullard camp.

Today we got the release of CPI data for July. It showed the 4th straight month of YoY core CPI less than 1% (0.9% all four months).

To the Fed, this is cause enough for heart palpitations. The details of the CPI release, however, show an even bleaker picture than that. Roughly 16% of core CPI is transportation ex-gasoline (mostly vehicle prices). Here's a chart of the transportation component of CPI -- prices fell dramatically between the summer of 2008 and early 2009 before recovering as auto manufacturing output slowed and cash for clunkers gave demand a boost. However, this effect has now peaked out, and transportation costs have been flat for the entire year. With transportation costs up 5% YoY, and transportation comprising 16% of core CPI, this means that transportation alone contributed 0.8% of the 0.9% gain for core CPI. Strip that out, since transportation costs have now flatlined, and core CPI is 0.

Which brings us to 1994. May of 1994 was the first month where Japanese YoY core CPI was below 1% for four straight months.

1994 was a challenging year for fund managers. There were some high-profile debt blowups (notably Orange County), Japan was entering the winter of its deflationary funk, and the Fed was preparing to hike like crazy. US 2-year treasury rates rose from 4% to 7.5% by the end of the year. It's also the last year the Fed conducted any sort of responsible monetary policy.

The realization that deflation was setting in, along with a US bond market slamming on the brakes, surely combined with other factors, was too much for Japanese asset markets to take. The middle of 1994 turned out to be a significant peak for Japanese equities and Japanese long-term rates, as the TOPIX fell by nearly 30% and the 20-year JGB yield fell by nearly 200bps over the ensuing 12 months.

The takeaways from Japan is that once a country enters a balance sheet recession and consumers, corporations, and banks have no interest in taking on more debt, the economy stumbles along at a near 0% growth rate, making it susceptible to external shocks such as financial crises or policy tightening in other large economies.

The US, I'd argue, has entered a phase similar to where Japan was in the early to mid '90s. The credit mechanism has broken, and a balance sheet recession/depression is underway, with "trend" GDP likely to be around 1% for the foreseeable future. We are now susceptible to the same shocks Japan was in the 1990s. Already this year we've seen Europe talk about, and will soon implement, fiscal austerity measures. At the same time, the BRIC country and commodity currency countries have tightened monetary policy. India has hiked rates 4 times this year with short-term rates rising from 3.25% to 4.50%. In Brazil, it's been 3 hikes from 8.75% to 10.75%. In Australia, 3 hikes from 3.75% to 4.50%. And in Canada, 2 hikes from 0.25% to 0.75%.

Look for the sum of these measures, along with any sort of financial shock, to negatively impact US asset markets and hence the US economy in the second half of the year. With the Fed's sweaty finger twitching on the QE2 button, 30-year bond rates near 4% will look like a bargain 6 months from now.