Santa’s Gift to the U.S.: A Potential Deflation Spiral

Step outside for a while and you might see more than just snow falling. That’s right, in the U.S., prices are on the brink of falling as well!

The headline consumer price index (CPI) showed that prices of consumer goods and services were unchanged in November as it failed to meet expectations which called for a 0.1% rise.

Two of the biggest contributors to the headline CPI figure, food and energy, remained subdued in the month as food prices rose just 0.1% while gas prices dropped 2.4%. This explains why the core CPI, which covers all items less food and energy, recorded a 0.2% gain last month.

To be honest, it’s sort of alarming to see such numbers at a time like this. The global economy is already facing considerable threats to growth, what with Europe neck-deep in debt problems and China facing headwinds of its own. Even countries that had recently experienced rapid growth, such as Brazil and India, are starting to show signs of slowing down.

With worldwide demand crumbling, all of this suggests that the U.S. may see weak inflation in the months to come. Heck, it’s already teetering on the brink of deflation as it is!

Falling prices? Isn’t that a good thing? Ah, this is a question commonly asked of me when I talk about deflation.

While it is true that falling prices can be beneficial for consumers who run a tight budget, its positive effects are only temporary. When prices are falling, the profitability of companies also decreases, leading to lower investment, wages, and hiring. This, in turn, could lead to even weaker demand and lower prices, creating a never-ending deflationary spiral.

History can attest to this. In the 1930-1933 recession in the U.S. (known as the Great Depression), the annual rate of deflation stood at a whopping 10%. Demand was almost non-existent, which hurt prices, hiring, and business investment. The result was the unemployment rate surging as high as 25%.

With the year coming to an end and the U.S. on the brink of deflation, will things become much worse in 2012? I don’t know for certain, but the facts are clear.

The Fed has done everything in its monetary policy arsenal – from cutting rates to near-zero levels, to injecting billions of dollars into the economy, to implementing “Operation Twist” – to stimulate growth yet nothing significant has really happened.

To me, this tells us that inflation will likely be very low for the coming year, with the risk of the U.S. falling into a deflationary spiral present. What’s your take on the matter?