IS DEFLATION on the horizon? With all the money being pumped into the worldwide economy and our large state and federal deficits, many investors are preparing for a surge of inflation sometime down the road. Logically, that makes sense–but is that what will really happen?

 

Yes, the U.S. government has tried to pump, prime, and print its way to economic growth, but that has its limits. This money has to find a productive use or else it won’t “stimulate.” Here are a few things that are blocking our stimulus money from stimulating the economy.

 

First, banks have excess cash. Bank lending plays an important role in transforming easy money into economic growth. Unfortunately, banks are sitting on nearly $1 trillion of excess reserves at the Federal Reserve, up from essentially zero in the fall of 2008, according to data from the St. Louis Federal Reserve Bank. This is $1 trillion above and beyond reserve requirements, which means banks could use that money to lend to businesses and consumers instead of keeping it safe and secure with the Fed.

 

Second, the unemployment rate is near 10% and jobless claims are remaining stubbornly high. It’s hard for consumers to spend when they are out of a job or worried about losing one.

 

Third, consumers are de-leveraging and paying down debt. By paying off their bills, consumers have less money to spend on goods and services. Less spending may lead to less economic growth.

 

Fourth, because of the deep recession, the U.S. has substantial excess capacity in its industrial sector. According to the Federal Reserve, capacity utilization was only 72.6% in January, which is well below the 1972-2009 average of 80.6%. With all this slack, there may be little upward pressure on prices because factories have room to add production.

 

Fifth, a little followed economic indicator from the Dallas Federal Reserve Bank called the Trimmed Mean Inflation Index (TMII) is declining. This is an alternative measure of inflation, which adjusts for the month-to-month noise found in more popular inflation measures like CPI. For the 12 months ending December 2009, the TMII (inflation rate) was 1.3%–the lowest rate on record dating back to 1978.

 

So, while many people are talking about inflation, we also have to consider the possibility that deflation could happen first and then be followed by inflation down the road. It may not be a high probability, but it is on our radar and could impact the markets if it comes to fruition.