Beware Deflation

Member Group : Lincoln Institute

Much of the European Union and Japan have been beleaguered by a monetary policy characterized by negative interest rates.

In Europe, Germany, Austria, the Netherlands, Sweden, and Switzerland all have negative interest rates for bonds up to and including two-year bonds. This means that you have to pay a government in order to lend them money?!?

In a September 2015 press conference, Federal Reserve Chair Yellen indicated that negative interest rates were not something that the Federal Reserve considered very seriously. However, she noted that one participant in the committee "would like to see additional accommodation with things such as negative interest rates". She left the option open to negative interest rates in the future if conditions dictated.

To quote Chairperson Yellen: "CHAIR YELLEN. So, let me be clear that negative interest rates was not something that we considered very seriously at all today. It’s—was not one of our main policy options. But one participant in the Committee would like to see additional accommodation, is concerned by the inflation outlook, and thinks that we need additional stimulus, additional accommodation to provide that, and proposed doing so by moving interest rates negative. That’s something we’ve seen in several European countries. It’s not something we talked about today. Look, if—I don’t expect that we’re going to be in a path of providing additional accommodation, but if the outlook were to change in a way that most of my colleagues and I do not expect and we found ourselves with a weak economy that needed additional stimulus, we would look at all of our available tools, and that would be something that we would evaluate in that kind of context."

What was not found in her comments were the words deflation or deflation expectations. The Fed continued to reaffirm its inflation goal of 2% which it has steadfastly maintained since it gave additional guidance in its long term outlook in 2014.

Since that September 2015 press conference, the Federal Reserve has not been able to raise interest rates in October and has delayed a decision on interest rates until the December 2015 meeting (when interest rates were raises .25%.)

The dangers to our economy of not understanding and dealing with a potential deflationary spiral are severe. This unwillingness on the part of the Federal Reserve to recognize such dangers in the economy is negligent at best. Deflation is occurring throughout the economy, first in real estate, then the stock market (which has recovered), real disposable income, oil and commodities.

It is essential to remember the Federal Reserve is the same agency which presided over the housing and the bubbles.

The danger of not understanding and dealing with deflation is that a deflationary spiral is extraordinarily difficult to stop. Inflation, while costly to citizens, is conceptually easy to contain.

Deflation creates an implosion of any economy saddled with debt since that debt is more expensive to repay.

Negative interest rates and deflation make it extremely difficult for those who are in debt to repay that debt which further dampens the outlook for economic growth and may potentially collapse the economy.

With virtually zero interest rates in the United States for over six years, savers and those close to retirement are paying a monetary policy penalty such that their savings are earning little to no income causing further depletion of retirement funds once they stop working.

With interest rates on government securities at zero and potentially below zero, Social Security trust funds, which are only invested in government securities, are woefully underperforming the repayment obligations to Social Security recipients. This shortfall in Social Security funding performance almost certainly reinforces the underfunded nature of the Social Security trust funds and our eventual inability to meet those commitments. Social Security is but one more example of a monetary policy penalty.

In a note of irony, this monetary policy penalty may actually become a massive tax increase on all citizens of the United States. Should interest rates go negative, the federal government will actually make money by going into debt because they will now earn interest income on debt obligations which would save almost $500 billion a year in expenditures. It essentially becomes a tax on savings or another monetary policy penalty.

The reality of all of this absurdity is that failing to deal with the core issue of deflation, excessive government deficits, and massive debt loads at the federal, state, student loan, and consumer loan levels is increasing the likelihood of a massive deflationary spiral in the United States and the world.

To properly defeat the problems that our nation and our economy are undergoing, defeating deflation must be the goal and current inflation targets should be goals rather than ceilings. Instead of trying to keep inflation under 2%, the Federal Reserve should be attempting to spur on modest inflation to reverse this deflationary spiral. A better alternative however would be for the Federal Reserve to stop manipulating monetary policy altogether, and for the federal government to stop spending beyond its means.

The problem of deflation is serious. The economic quagmire of the past 20 years is coming to a head. The monetary policy penalty is being felt by everyone and will make the ghost of 1937 look pale by comparison.

Col. Frank Ryan, CPA, USMCR (Ret) and served in Iraq and briefly in Afghanistan and specializes in corporate restructuring and lectures on ethics for the state CPA societies. He has served on numerous boards of publicly traded and non-profit organizations. He can be reached at [email protected] and twitter at @fryan1951.