Rising job losses and “unusual uncertainty” within the economy have prompted the Federal Reserve and other major financial institutions to slash growth projections for the rest of 2010, leaving Americans worried about the possibility of a dreaded “double-dip” recession. But it’s another “D” word that currently has investors spooked—deflation.
With mortgage rates at record lows and Treasury rates at their lowest since March 2009—when the S&P dropped all the way to its ominous 666 bottom—the markets aren’t just hedging against the possibility of deflation; they’re expecting it. Todd Harrison, founder and CEO of the financial news and commentary site Minyanville.com, isn’t surprised.
“All roads ultimately lead to deflation,” explained Harrison in an interview with The Daily Caller. “We should have been allowed to take our medicine after the tech crash, but instead, the government gave us fiscal and monetary painkillers to reflate the market. It was about masking the symptoms rather than addressing the disease. Now we have a ‘last gasp’ to reflate one more time. ”
That “last gasp” is already stalling. According to the Bureau of Labor Statistics, after massive economic intervention by the government and Federal Reserve generated moderate inflation in the second half of 2009, total inflation in 2010 has been 0.0%. July’s slight uptick in prices generated positive headlines, but the news was tempered by the fact that, after accounting for volatile food and energy swings, monthly inflation had actually slowed.
Deflation concerns at the Fed have risen as the recovery has stumbled. James Bullard, president of the St. Louis Fed, warned that the economy is at risk of “a Japanese-style deflationary outcome” before last week’s Federal Reserve meeting, which concluded with the decision to effectively “re-print” money originally created to fight the deflation of 2008.
The problem, said Harrison, is the extreme level of debt weighing down on the economy. “The debt virus has infected all three levels—consumer, corporate, and government. We’re at the beginning of a debt unwind that’s going to take years, and the destruction of debt is a bitter pill to swallow.”
Upside-down households across the country are trying to pay down their debts, with outstanding consumer credit contracting in 19 of the past 21 months. But as Americans retreat, their reduced spending on goods and services causes prices to fall. “It certainly looks like households are tapped out,” said Rolfe Winkler of the Wall Street Journal via email. “Debt to disposable income is finally starting to come down after at least 60 years of expansion. That’s as far back as the Federal Reserve’s data goes.”
Recent Fed bank surveys also suggest that, overall, credit is contracting because of a lack of demand for loans, not because of a lack of willing lenders. Harm Bandholz, UniCredit Global Research’s chief U.S. economist, told Bloomberg that “it’s mainly a [credit] demand problem, and not so much about credit supply. The private sector is not responding to low interest rates and easing credit conditions.”
This sea change in debt accumulation could mean that the Fed is nearly out of ammo when it comes to fighting deflation. If consumers are unwilling to borrow more when interest rates are at historic lows, Ben Bernanke may once again have to choose between allowing prices to fall across the economy and printing even more new money for the government—and even that may not be enough.
“Sure, the federal government can lever up to replace private leverage,” said Winkler. “But to what end? Stuffing the system with more credit in order to prop up prices will just cause the economy to calcify…. There is no monetary or fiscal policy that can permanently push back the tide of debt. We can stall it. But it’s going to wash away a lot.”
Still, not everyone is convinced that the U.S. economy is headed for deflation. Some argue that economic indicators are merely pointing towards an environment of subdued, but existent, inflation.
“Although discouraging, the recent softness in the economic data looks much more like a bump in the road of what we already thought would be a gradual recovery, rather than a swerve into the ditch,” said San Francisco Fed Director of Research John C. Williams at a California luncheon at the end of July. “The Fed will do what it takes to eventually return to and maintain a low, positive rate of inflation.”