October 2010

Months ago, when the U.S. economy showed nascent signs of growth, fears slowly emerged that inflation could accompany the recovery and prompt central bank policymakers to tighten their grip on credit.

Now, some of those so-called “green shoots” have lost their original vigor, and talk has turned to fears that deflation — when prices decline as demand wanes — might crop up instead. What should investors realistically expect?

Paul Kasriel, Northern Trust’s chief economist, thinks the most likely scenario is that the United States will avoid a double-dip recession and experience very moderate inflation. “But if I were to put risks around that most likely scenario, the risks are tilted toward deflation versus a sharp acceleration in inflation in the next two years. Again, that’s not the most likely case, but that’s the risk case.”

Kasriel notes several reasons for his forecast, chief among them the still-tight bank credit situation.

“I hate to be a ‘Johnny One-Note,’ by relating so much that has happened — or is likely to happen in the economy to bank credit, but it’s really important. What happens to bank credit today historically has had a lot to do with what happens to inflation two years from now,” Kasriel said. “In 2009, we saw the most severe contraction in bank credit in the post-war era. That would suggest that over the next two years, we’re not going to see a lot in terms of inflation, but maybe some deflation.”

Typically, deflation is associated with stagnant economic growth, such as during the U.S. Great Depression or Japan’s so-called “Lost Decade” during the 1990s, as would-be buyers postpone purchases because they expect prices to drop even farther. Consumer spending is vital to economic growth because it accounts for some two-thirds of the nation’s gross domestic product.

Right now, inflation has slackened to the point where the Federal Reserve is concerned about possible deflation. Core consumer-level inflation was up 1.4% in the 12 months ending in July, below the Fed’s comfort zone of 1.7%–2.0%. Worries that the economy could weaken more if consumers continue to hold back from spending has the Fed searching for more “dry powder” to ignite the economy in case the outlook deteriorates sharply. In fact, the central bank at its September meeting indicated that policymakers would watch closely the direction of inflation as they mull their next move.

“The jobs market, where unemployment has stuck at more than 9.5%, also seems an unlikely source of wage-based inflation,” Kasriel said.

“It’s not likely that we’re going to see a lot of labor cost pressures any time soon,” he added. “The economy in general is operating below its potential, with a lot of spare capacity not only in the labor market but in the factory market as well. So, this is not the environment for higher inflation. In fact, again, the risk would be toward deflation.”