What's Preventing Inflation?

By Geoffrey Michael | September 16, 2010 AAA
What's Preventing Inflation?

Under normal economic conditions, the U. S. would be experiencing high inflation as a result of the billions in stimulus spending and the Federal Reserve's monetary policies. The combination of unprecedented deficit spending and cheap money has not been reflected in retail prices - at least not yet.

What is preventing the onset of inflation? Here are a few of the current economic factors that are keeping prices in check. (For an in depth primer, see out Inflation Tutorial.)

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High Unemployment
The law of supply and demand may be the most basic of economic principles, but it certainly applies to today's situation. When the credit bubble burst in 2008, many companies were left with large inventories and vanishing demand. As unemployment rose, consumer sentiment plummeted which was quickly reflected in falling retail sales.

Dale Furtwengler, author and president of Furtwengler & Associates, says that "because of the large number of people out of work, almost twice the norm, people are being cautious in their spending which is keeping demand low relative to supply … Similarly, because there are a plethora of workers available and many more underemployed, there's no reason for companies to bid for talent."

High unemployment is also reflective of excess capacity, as explained by Max Bublitz, chief strategist, SCM Advisors.

"The Congressional Budget Office recently estimated that real GDP (ex-inflation) is currently more than 6% below its 'potential' level, reflecting significant excess capacity in the economy. In econo-wonk terms, this is known as the 'output gap,' which is defined as the difference between actual GDP and the level of GDP above which inflation pressures begin to grow."

In order to shrink the excess capacity, increase employment and avoid deflation, sustained GDP growth exceeding around 2.5% is needed. According to the U.S. Department of Commerce, GDP grew 1.6% for the second quarter of 2010, well below what is needed for a recovery.

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Tight Money
While a decade of easy money has been cited as one of the chief reasons for inflating the housing bubble, most people and businesses find that it's now much harder to obtain a loan of any kind.

Ryan Himmel, CPA and founder of BIDaWIZ, states that "the purpose of the monies that the Federal Reserve provided was to shore up bank balance sheets with the hope of increasing the rate of lending; this hasn't exactly happened."

While most banks are healthier than they were two years ago, tighter lending policies have discouraged investment. Since banks were severely hurt by bad mortgages, the inevitable result was a return to stricter loan requirements such as verifiable income and down payments.

Lower Oil Prices
The cost of oil has a significant impact on prices for everything from fuel to plastics. Thousands of products are petroleum-based, so every additional dollar for a barrel of oil ripples throughout the economy in the form of higher prices.

In July 2008, oil peaked at roughly $145 per barrel. Over the next several months the price fell precipitously as banks failed and the government bailouts began. By the end of the year, a barrel had dropped almost 80% to just over $30. While the price of oil has since risen to around $75 per barrel, it's still well below the peak and has acted as a damper on inflation. (Learn more about inflation and oil in Inflation: The Inside Story.)

The Demise of the Debt-driven Consumer
The U.S. is now witnessing the unwinding of a giant credit bubble that was concentrated in residential real estate, but extended well beyond home mortgages. It was not unusual for homeowners to be over-extended beyond their means to pay, through a combination of home equity loans, credit cards and personal loans.

What resulted is described by Rodney Johnson, president of HS Dent. "As it always does, this bubble inflated beyond any sustainable level and caved in on itself. Consumers had over 130% of debt to discretionary income, the highest level in history and almost twice the long term average. Unfortunately, we depended on this growing flow of debt to keep our spending high and our country employed. Now it's over." (Learn more about your rights in The Dark Side Of Debt Collection.)

Consumers are saving more of their money and looking for bargains when they shop. According to Johnson, they are reducing their leverage by "paying off debt, either by choice (not renewing loans, paying off vehicles, paying off credit cards) or by force (mortgage foreclosures, boat and car repossessions, credit card charge-offs)."

The Bottom Line
The lack of any serious inflation is today's news. While consumers benefit as prices remain under control, the greater risk may be a deflationary spiral that cuts asset values before a sustainable economic recovery takes hold.

The combination of deficit spending and current Federal Reserve policies acts as a counterweight to deflation. It remains to be seen how this will play out since those policies could also result in hyperinflation at some point in the future. (To learn more, see The Importance Of Inflation And GDP.)

For the latest financial news, see Water Cooler Finance: Mergers, Hostile Bids And SEC Probes.

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