This chart illustrates the strong tendency of Federal Reserve monetary policy to follow the ups and downs in the economy. Capacity Utilization (blue line) is a proxy for the strength of the economy, and the real Fed funds rate (red line) is a good measure of how tight or loose monetary policy is. The stronger the economy, the more the Fed is prone to tighten monetary policy by increasing the real Fed funds rate, and the weaker the economy, the lower the real funds rate.
Capacity utilization has literally soared in the current recovery, as the manufacturing sector has enjoyed a V-shaped recovery with no end yet in sight, but the Fed continues to keep monetary policy very accommodative. Ordinarily this would be highly disturbing, since it would point to accelerating inflation pressures. But this time around things are very different, given the troubles in Europe which have greatly increased the world's demand for dollar liquidity. The Fed understandably wants to be sure there is no shortage of safe-haven dollars in the banking system to satisfy the world's apparently insatiable demand for them. If the Fed were only concerned about the US economy, they would not be keeping interest rates so low for so long, because the great majority of economic indicators—industrial production and residential construction numbers released today being the two most recent examples—point to continued US economic growth.
The behavior of gold, commodities and the dollar in the past year or so also supports the Fed's decision to keep policy very accommodative. The CRB Spot Commodity index is off 17% from last year's high, and gold has dropped 19% from last September's high, and the dollar is up some 13% from last year's low against other major currencies. All three of these key indicators of monetary conditions are consistent with strong demand for dollar liquidity—and some would even say these moves are symptomatic of a relative shortage of dollars. I'm not prepared to accept that dollars are in short supply, however, since these same charts show that gold and commodity prices are still very high from an historical perspective, and the dollar is still very weak. Instead, I would argue that on the margin there has been an increase in dollar demand relative to supply, but that dollars are still relatively abundant from a broader perspective.
In other words, I don't see any emerging deflationary pressures resulting from the recent weakness in gold and commodities and the strength of the dollar, but rather an easing of inflationary pressures. That is confirmed by the relatively tame readings we saw in yesterday's CPI release, as illustrated in the above chart. So far, so good.
The big thing to watch for is an easing of the tensions in Europe, since this has the potential to dramatically change the world's demand for dollars, and that in turn could result in monetary policy becoming once again inflationary—unless the Fed takes decisive steps to mop up any excess dollar liquidity by either draining reserves or increasing the interest rate it pays on reserves.
UPDATE: I should add the obvious, which is that the first chart suggests that the real Fed funds rate should be approximately 2% by now, if everything else were normal. To get there, given that the core PCE deflator is currently 2% and assuming that the Eurozone situation were to normalize by the end of this year, the Fed would need to raise the funds rate to somewhere in the neighborhood of 4%, and that could be done over the course of a year or two. That would undoubtedly be tough on the T-note and T-bond markets, but not insurmountable, particularly since the steepness of the yield curve implies that some degree of tightening is quite likely. The pain of raising rates is probably exaggerated: For one, a healthier Europe would almost surely be a boost to the US economy, and a stronger economy would boost tax revenues. If spending growth can be held in check, a stronger economy would all by itself bring the deficit down to manageable levels (3-4% of GDP) within a few years. In fact, we're already halfway there: the deficit as a % of GDP is down from a high of 10.4% to the current 7.4%. In other words, as the market loses its desire for Treasuries, the government's need to sell Treasuries would be declining at the same time. The solution to all this is not impossible by any means.