2015: A Year Without Inflation?

Just a couple of months ago, market pundits were still discussing the possibility that the anti-recessionary Quantitative Easing (QE) policy of the Federal Reserve Bank of the United States would lead to “raging inflation” in the American economy. Have they been proven correct?

Hardly. Health care cost inflation, for instance, continues to remain below 5%, where it has lingered for the past five years. And energy costs have actually plummeted this year, with the price of a barrel of crude oil falling by well over 40%.

The implications of such low inflation rates may be profoundly positive for the American economy. After all, low inflation rates tend to be reflected in low interest rates. And when bank loan rates are low, organizations can better afford to finance speculative projects with costs that are significant in the short term and benefits that can only be recognized in the relatively distant future.

Such projects often promote the long term competitiveness of the American economy. Do you suport investments in renewable energy technologies, for instance? Driverless automobiles? Drugs to cure cancer? These investments are not likely to pay off in the near future, but in an extremely low rate environment, more organizations may be willing to pay for such projects.

There is a risk, though, that inflation and interest rates might plummet below the “zero lower bound” and actually become negative in direction. That hasn’t yet happened in the United States on an annual basis; even though energy costs have been dropping significantly and the Consumer Price Index (CPI) declined by a nominal 0.3% in November 2014, the annual CPI remained at positive 1.3% through that month.

But what could happen if inflation drops significantly below zero? If consumers and businesses become convinced that prices will continue to fall over time, they could stop spending money today and delay their purchases and investments in order to wait for a lower cost future.

Such debilitating deflationary psychology has plagued the Japanese economy for two decades. The European Central Bank (ECB) is reportedly worried that deflation and its effects may soon strike the European Union as well.

So there is a very real risk that an American bout of outright deflation may derail its economic recovery. Nevertheless, if the upcoming year features very low (or no) inflation, the economy of the United States may continue to serve as the engine that drives global prosperity.