Deflation, not inflation, remains the bigger threat to the economy in 2009

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Is an increase in inflation in the cards for the United States? The inflation hawks certainly sense there's inflation up ahead given the roughly $10 trillion in stimulus the U.S. government and Federal Reserve have provided to the financial system to address both the financial crisis and the recession. They are always at the ready to recommend a tighter monetary policy and offer amendment after amendment on the U.S. Senate's floor to limit or reduce fiscal spending.

Further, China is so concerned about potentially higher U.S. inflation -- and the impact it would have on its dollar-based investments (mostly bonds) -- that it has recommended changing the international monetary system so that a global currency or a 'supercurrency' serves as the world's primary reserve currency, not the U.S. dollar.

The inflation equation

Well, before you start to convert part of your portfolio to gold or buying Japanese yen by the truck load, let's take a moment to systematically and professionally look at the inflation issue.

Yes, the U.S. government has provided fiscal stimulus to jump-start the economy and the Fed has gone 'superquantitative,' implementing an expanded quantitative easing monetary policy. But those two represent only one half of the ledger.

Here's the other half: For one, U.S. and global stock prices, which are down substantially on a year-over-year basis, with about $50 trillion in asset destruction, according to research sponsored by Asian Development Bank, Bloomberg News reported. Another example are U.S. housing prices, which are not only down more than 10 percent from a year ago, but also the home-equity cash cow that drove consumer demand and that pushed prices higher is a fraction of its previous self.

And how about wage pressure? It's virtually non-existent in most job categories, professional through blue collar. Corporate pricing power? Well, some sectors have modest pricing power, but in general, given slack demand, most businesses are simply trying to avoid price cuts to encourage sales. In other words, prices at the retail and wholesale level are contained -- another sign of low inflation. True, commodity prices, in particular copper and oil, have rebounded, but keep in mind that these categories are coming off massive drops following the end of the leveraging bubble.

Hence, from the above we can see that although the U.S. fiscal and monetary policy have been expansionary, asset destruction, commodity price drops, no wage pressure, and little corporate pricing power have taken many more dollars out of circulation; compared to a year ago, the U.S. economy is still well net-negative dollars.

Now consider the impact of large U.S. inventories. Those products can't stay on shelves forever but have to be sold. Given slack demand, many businesses will have to offer incentives to 'get the stuff out the door,' which suggests little pricing power as the U.S. economic recovery starts.

Economic Analysis: On balance, deflation, not inflation, remains the bigger threat to the U.S. economy, for at least the next 12 months, and most likely for a considerably longer period.

Deflation -- a protracted, systematic decline in prices and wages -- occurs in pronounced recessions and other conditions where demand is non-existent and it robs companies of the ability to increase revenue and hurts the economy's ability to grow. If it takes hold, that's another hurdle policy makers will have to grapple with as they attempt to end the U.S. and global recessions.

U.S. inflation may begin to present a problem after demand picks up, but so far there's little sign that consumer- and business-based demand is going to register a net-increase on a year-over-year basis in the immediate quarters ahead.

Financial Editor Joseph Lazzaro is based in New York.
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