The Fed has created investor concern by stumbling away from its hope of 2% inflation. That concern has given rise to a polarizing inflation/deflation debate. With a fragile recovery at stake, the Fed struggles against overcoming persistently low inflation rates and losing the public’s faith. At the same time, investors build their cases for inflation or deflation; each side posing strong arguments for why either threatens the US economy.
Evidence of Deflation
Investors who find themselves in the deflation camp argue that fears that the European Central Bank’s bond buying program will make the euro less attractive and send investors flocking to rising currencies. As a result, European growth will improve, but at the expense of growth in the US, Switzerland, and other countries with strong currencies.
Moreover, January 2015 marked the third month in a row that prices for goods declined, clearly discouraging hope of a healthy growing US economy. With a -0.1% price decline in January, goods actually cost less than they did one year ago. Similar to 2009, deflation affects falling prices, consumer spending, and adds pressure to corporate profit margins, typically spawning wage reductions and increased unemployment.
Not to mention, some dispute whether quantitative easing even worked. The Fed made huge bond purchases with the intention of increasing the money supply. Ideally, central bank asset purchases should increase bank reserves and the money supply, resulting in increased lending by banks. However, in reality, banks were so panicked during the financial crisis that they held on to the excess money and did not lend. There can’t be inflation without lending.
Argument for Inflation
Conversely, investors in the inflation camp argue that the energy sector, especially cheap gas prices, is the primary driver of falling goods prices. Moreover, they believe recent price stabilizing marks the beginning of increasing gas prices moving forward. Essentially, as gas prices rebound, the inflation figures should also put deflation worries to bed.
What’s more, if you exclude energy from consumer prices, staples such as food, shelter, and medical care have increased 1.9% from 2014. When the most volatile categories like food and fuel are removed from the equation, core inflation is steady and up 1.6% from last January. These numbers reflect the economy being more in line with the Fed’s 2% goal.
Despite looming worries, economists are still optimistic about the overall improvement of the US economy. Many credit quantitative easing for keeping interest rates low, building job creation opportunities, and preventing the Great Recession from becoming the second Great Depression. However, it is also important to note that critics of quantitative easing say that a long-term effect could be high inflation.
The Verdict
This is not a black and white issue. There are areas of inflation and deflation pulling the US economy in both directions. We are watching bank stability, consumer spending, and credit to monitor the situation. Yet, taking the glass half full perspective, investors can be comforted that the United States’ core inflation is key in differentiating the U.S. economy from more challenging economies like Japan and the Eurozone.
