I would welcome deflation with open arms. It would be rough on the economy, but I think it would be much better in the long run. However, I think our government and the Federal Reserve will do everything in their power to make sure we stay inflationary. The last time we had any deflation was back in 1955 and it was 0.37% which is basically stagflation. The last time we had any meaningful deflation was back in 1933 and it was 5.11%. So at least historically from a statistical point, the odds are against deflation. The only way I think deflation would even be possible at this point is if we defaulted on our debt obligations but that would instantly crush the U.S. dollar. We have had some more recent moments that felt like deflation, but they were simply the effects of lower inflation. The early 80's felt like deflation because inflation fell from 13.50% in 1980 down to 3.00% in 1986. The only reason that happened was because the Federal Reserve raised the national interest rate dramatically in order to avoid hyper-inflation. You probably remember those years. That was when a home mortgage had an interest rate of 20%. Back then we had less than $1 trillion in debt and foreign countries were more than happy to buy our U.S. Treasury bonds with the new high interest rate. They made great returns on their investment. What we avoided in hyper-inflation we made up for in national debt. Our national debt was climbing at a rate 34.87% by 1986 and we hit $3 trillion in debt by 1990.
That brings us to our problem today.
- Our 2009 inflation was 7.5% with an annual averaged national debt of $12 trillion growing at a rate of 18.8%.
- Our 2010 inflation was 8% with an annual averaged national debt of $13.5 trillion growing at a rate of 13.87%.
- Our 2011 inflation is 8.5% with a national debt already above $14 trillion and climbing fast.
Inflation will keep climbing fast as long as the Federal Reserve keeps the national interest rate at such a low level. I think the national interest rate is currently at 0.25%. If the Federal Reserve tries avoiding hyper-inflation by raising the national interest rate like they did back in the 80's it will send our national debt through the roof. Could you imagine a national debt rate of 35% like we had back in the 80's? Back then we didn't have nearly the kind of national debt we have now and taxes paid for nearly all our federal spending. That's not the case today. 2010 taxes brought in $2.281 trillion while government expenditures were $3.552 trillion leaving a gap of $1.271 trillion. That's huge! That gap is estimated to be $1.7 trillion for 2011. I bet it will be more like $2 trillion. Government projections typically low ball it. So even if we can temporarily force inflation lower, it will send our national debt much higher which will lead to higher inflation shortly down the road as we must service all the new debt at a much higher interest rate. I just don't see how we can get out of what appears to be a catch 22.
Oh, and just so you know. Quantitative easing (QE) is just a fancy phrase the Federal Reserve created. It is still the same old routine. They are buying large amounts of U.S. Treasury bonds and they are adding loads more money to the banking industry's discount window. The interesting thing right now is that banks are too scared to give out loans right now because of the housing bust. Most of the money added to the discount window from the last QE is still there waiting to be used. If at some point banks decide to start loaning again we will see all that QE run through the fractional banking system and multiply up to 10 fold. There is potential for massive inflation from that alone.
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