Deflation is Taking Hold in Some Economies. Is the US Next?

In response to the 2008 financial crisis and resulting Great Recession, the Federal Reserve (followed by central banks around the world) slashed interest rates to near zero and engaged in a policy of unprecedented money printing, known as "quantitative easing."

This combination spurred concerns that inflation would accelerate, perhaps rampantly.

But that hasn't occurred — at least not yet.

The pace of inflation over the past 12 months fell to 1.3% in November and is down sharply from 2.1% just five months ago.

The Federal Reserve has a publicly stated goal of 2% annual inflation. As recently as 2011, the US inflation rate averaged 3.2%. But the rate dropped to 2.1% in 2012 and then 1.5% in 2013. The steady decline is clear.

The financial world has been cautiously watching and waiting for any indication that the Federal Reserve will raise interest rates next year.

However, bond guru Bill Gross says the Fed may refrain from hiking rates in 2015 due to a lack of inflation.

"Why would the Federal Reserve raise interest rates in order to slow economic growth if inflation in fact was moving lower?"

It's an excellent question; one that many of us are asking. Oil is tumbling and cheaper energy means lower inflation.

In fact, the bigger concern at the moment is deflation, which is rearing its ugly head around the world.

Delation is the continual decline in prices and assets. It is often associated with a reduction in the money supply, or credit.

While the money supply has certainly expanded in an unprecedented manner (the Fed’s balance sheet has expanded from about $850 billion to more than $4.4 trillion since the 2008 financial crisis), economic demand and consumer spending remain weak.

Though Americans have paid down much of their household debts (including car loans, credit cards, student loans and home mortgages) from 130% of disposable personal income in 2007 to 103% today, the fact remains that households still have more debt than disposable income. That is holding back spending.

Ultra low interest rates were supposed to be a temporary inducement to get households borrowing again and reverse the housing bust. But six years later, though rates remain at historic lows, mortgage lending remains weak.

The US homeownership rate fell to 64.4 percent in the third quarter, the lowest level since early 1995. First-time buyers have been kept out of the market by strict lending standards and low wages.

Weak and steadily falling inflation, plus weak demand, is raising fears of deflation.

Investopedia explains deflation this way:

"Declining prices, if they persist, generally create a vicious spiral of negatives such as falling profits, closing factories, shrinking employment and incomes, and increasing defaults on loans by companies and individuals."

Japan, most famously, has been battling deflation for two decades. The Bank of Japan had a zero interest rate policy in affect for many years, which didn't cure the problem. Then the BOJ initiated its own massive money-printing scheme last year, which has also failed.

Falling prices have hurt consumption in Japan, as consumers wait for prices to keep dropping before spending. If consumers refrain from spending long enough, it hurts corporate profits. That limits hiring and can even lead to layoffs. This vicious circle has led Japan back into recession.

There are concerns that the euro zone could be plagued by deflation in 2015. As it stands, Sweden and Spain are already grappling with its menace.

Now, some economists and analysts are concerned about the possibility of deflation arising in the US. It may not be that far-fetched, as the specter of deflation is growing globally.

Commodities — such as oil, gold and copper — have experienced serious declines this year.

The US economy has remained one of the lone bright spots on the global stage in 2014, but in a highly interconnected global economy, that could change quickly in 2015.

A lack of economic demand is a pernicious problem, which leads to a lack of consumption, fewer jobs, and a lower GDP.

Since consumer spending accounts for more than two-thirds of US economic activity (GDP), it's no surprise that this has been the weakest recovery since the Great Depression.

In fact, this is the first economic “recovery” in which median family income continues to drop. That is holding back consumer spending, which, in turn, is holding back economic growth.

Though the Great Recession is officially over, Americans are still 40% poorer today than they were in 2007, the year before the global financial crisis.

The net worth of American families — the difference between the values of their assets, including homes and investments, and liabilities — fell to $81,400 in 2013, a long way off from the $135,700 in 2007, according to a new report released this month by the nonprofit think-tank Pew Research Center in Washington, DC.

Over just the past year, incomes have barely budged. In November 2014, the average weekly wage was $853 versus $833 for November 2013, according to the Bureau of Labor Statistics.

Falling oil prices should allow Americans to spend more of their incomes on other things, which should buoy the economy. But if broader deflation sets in, lower oil prices won't matter. In fact, falling oil prices will just add fuel to deflationary forces.

While much of the decline in oil prices has been attributed to higher supplies, demand has also fallen around the world. The International Energy Agency has cut its estimates for demand for crude five times in the past six months, The Wall Street Journal reports.

Oil is the lubricant of the global economy and a lower demand indicates a slowing economy. Demand has fallen even in the US, where motorists are driving more fuel efficient vehicles and using less gas.

However, those trends could change in the face of tumbling oil and gas prices. Americans could revert to buying bigger, less efficient vehicles.

The diminishing demand for oil, and the robust drop in prices that has ensued, is sparking deflation concerns around the world.

The bond market has taken notice, as reported by Bloomberg:

"The difference in yields between Treasury two-year notes and comparable maturity inflation-indexed securities turned negative yesterday for the first time since the aftermath of the global financial crisis in 2009. The measure, known as the break-even rate, is generally seen as reflecting investors’ expectations for inflation over the life of the securities."

In other words, investors have abandoned all fears of inflation in the short term.

To be clear, the US is not in deflation at present, and it may not face it in 2015. But there are plenty of reasons to be concerned. Inflation, already below the Fed's target, is steadily declining.

The consumer price index fell by a seasonally adjusted 0.3% in November to mark the largest drop since December 2008, during the depths of the Great Recession.

The decline was driven by the sharp slide in gasoline prices. Energy costs fell for the fifth straight month, said the Labor Department, led by a 6.6% decline in the price of gasoline.

Here's the thing that really jumps out at me: If the Federal Reserve can add $4.4 trillion to the money supply in just six years — while dropping interest rates to near zero — without sparking rampant price inflation, some very powerful deflationary forces are surely working against it.

In other words, the US economy remains quite fragile as we head into 2015.

National Debt Surpasses $18 Trillion

A pretty major event took place recently, yet most people barely noticed.

The national debt eclipsed $18 trillion. That is a number so large that it is almost incomprehensible. For the record, a trillion has 12 zeros. A trillion is one thousand billion. So, 18 trillion is 18,000 times a billion.

Chew on that for a moment.

The U.S. economy totaled $16.77 trillion last year, according to the International Monetary Fund (IMF). If our economy grew by 2.8% in 2014, as the IMF projects, it will reach $17.24 trillion this year.

Obviously, that number is smaller than our national debt. But, quite critically, it also means that economic growth for the year was smaller than the budget deficit for the fiscal year.

According to the Congressional Budget Office (CBO), the federal budget deficit was $506 billion for fiscal 2014, which ended on September 30.

While that’s about a third the size of the deficit in 2009, during the depths of the Great Recession, it also means the deficit for a single year still surpassed half a trillion dollars.

The only good news in this story (and there are those who are surely spinning it as good news), is that the size of our annual deficits has shrunk in recent years. But the deficit is still massive by any reasonable measure.

The deficit has fallen from more than 10% of GDP in fiscal 2009 to only 2.9% of GDP in fiscal 2014. That puts the U.S. below the 3% limit at which the European Union requires member countries to take corrective action. The CBO expects us to remain near that level for the next five years.

While this is all very good news, it does not diminish the fact that the U.S. government is still spending more money than it collects in taxes, and therefore continues to add to the underlying national debt.

To be clear, the deficit represents excess spending above tax collections in any given fiscal year, while the debt is the sum total of decades of this excess.

The federal debt held by the public should reach 74% of GDP this year — the highest percentage since 1950. That was five years after WWII, so there was a good reason for all that debt back then.

The debt held by the public must be collected with taxes to pay off our creditors (i.e., Treasury bond holders). The rest of the public debt is money the government owes to its citizens for things such as Social Security and Medicare, plus military and civil service pensions, etc.

Since the government has already collected and spent these monies, it now needs to obtain additional funds to repay these debts. The government will either collect more taxes or make cuts to other budget items to repay the debts owed to the American people.

Social Security and Medicare are technically considered liabilities, not debts. Though the government has spent all the money in the Social Security Trust Fund on other budget items — and owes that money back to the people from which it was collected — it is still not considered "debt."

Including the national debt, the government's (meaning the taxpayer's) unfunded liabilities totaled $71 trillion at the end of fiscal 2013 (Sept. 30, 2013). It has since gone higher, though no official figure is currently available.

Ultimately, this debt belongs to us — the public — as well. We owe all of it, on behalf of our government. There is no differentiating our government's debts and liabilities. The taxpayers will fund it all in the end.

In order to stop adding to the debt, the government must first end it deficits — not merely lessen them.

In 2011, Congress and President Obama negotiated $1 trillion in cuts to discretionary domestic and defense spending over nearly a decade. Yet, this “sequestration” process still left us with annual deficits.

The government is currently being spared much higher debt payments because interest rates are historically low. But when rates are this low, they have only one way to go — up.

The 10-year Treasury currently yields 2.31%. Debt-service costs will be crippling when yields revert back to long term norms. For example, over the 20-year period from 1994 to 2013, the yield on the 10-year Treasury averaged 4.60%.

That's twice the current rate.

Since we're continually adding to the debt, it will make that eventual reversion all the more painful.

The U.S. public debt crossed the $1 trillion mark for the first time October 22, 1981. It took 205 years to get there. We've now added another trillion in roughly one year. And that's being heralded by some as progress.

This is very troubling, and the consequences will be quite harsh at some point in the future. It doesn't matter whether it's sooner or later. Some extraordinarily large debts are coming due, and they will impact all of us. They will impact our very way of life.

Money spent servicing our debts is money not spent on health, education, or our crumbling infrastructure.

In other words, the national debt is already robbing from our nation, and it will only get worse — much worse.

But here's the rub: Our entire monetary system is based on debt. In the absence of continually growing debts, the system will collapse. Yet, under the burden of all this debt, the system will eventually collapse anyway.

That makes for one hell of a predicament.

The only solution is to change the very essence of our debt-based, fiat monetary system.