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San Francisco Fed President Janet Yellen recently said there is no real threat of an inflation surge, and is instead expecting inflation to fall to around 1% over the next year. She also believes the risk of inflation remains very low, and that interest rates could remain near zero for several years.

Her commentary is in sharp contrast with numerous analysts and economists, who have argued that the government's massive liquidity injection and quantitative easing program will result in stagflation or even hyperinflation as soon as economic activity picks up.

What Yellen described is essentially stagnation, or economic stagnation, which is a prolonged period of slow economic growth, traditionally measured in terms of the GDP growth. Under some definitions, growth less than 2-3% per year is a sign of stagnation.

Japan has experienced economic stagnation for fifteen years. Adverse financial developments were at the center of Japan’s economic morass, which is no different from our current financial and banking crisis. Although recent data points to a gradually healing economy, the following are factors supportive of a stagnation scenario:

Extremely High Debt Levels

Between 1982 and 2007, the amount of total debt grew from $1.60 to $3.53 for each $1.00 of GDP. This was made possible as the cost of money fell from 15% to 20% in 1982 to the current near zero interest rate. As interest rates fell, consumers were able to take on more debt. Increased consumer debt levels boosted GDP over the last 25 years. Household debt has increased from $.44 in 1982 to $.98 for each dollar of GDP in 2007.

Higher Savings Rate

Columbia University professor Edmund Phelps, winner of the Nobel Prize in economics in 2006 said U.S. households may take as long as 15 years to rebuild wealth lost in the recession. U.S. household wealth fell by $1.3 trillion in the first quarter of 2009 after dropping by a record $4.9 trillion in the 4th quarter of 2008.

In addition, the largest demographic cohort in the history of mankind, the post WW II baby-boomer generation, has passed its spending peak. This is going to be a decade-long process of less spending, of more saving, and above all, of paying off excessive debt and recouping the wealth loss in this recession. The economic consequences are going to be profound and will affect all sectors of the economy.

The personal saving rate fell to near 0% in 2007 and early 2008. The last 12 months of the current recession have motivated individuals to increase the personal savings rate to 6.9% as of May 1, 2009, the highest in 15 years. This is part of the reason why the economy has been so weak since consumer spending represents 70% of our GDP.

Grim Labor Market

The gloomy job picture threatens any economic recovery. The unemployment rate hit 9.5% last month. Many now expect it to stay high for a long time, eventually reaching double digits. The broader measure of underemployed also rose to 16.5% in June. The latest employment figures indicate that with another 900,000 job losses by the end of the year, which is likely, an entire decade of employment gains will have been wiped out.

The U.S. industrial capacity utilization rate stood at 68.3% in May, a historic low. With so much excess capacity, businesses will not have to materially increase investment for at least the next 2 or 3 years. People facing unemployment or wage cuts are less able or willing to spend to stimulate the economy. One economic theory, the Phillips Curve, which is a historical inverse relationhip between the rate of unemployment and the rate of inflation in an economy, posits that such excess will reduce inflation as firms with idle capacity cut prices and workers facing layoffs accept smaller wage hikes.

Banks Are Not Lending

The level of lending is an important factor in determining how fast the economy will turn around. Lending at the biggest U.S. banks has fallen more sharply than realized, despite government efforts to pump billions of dollars into the financial system.

According to a Wall Street Journal analysis of Treasury Department data, the biggest recipients of taxpayer aid processed 23% less in new loans for February, the latest available data, than in October, the month the TARP program was initiated. One factor that may have masked the still tight credit conditions is the partial thawing of the corporate bond market, with a return of investors risk appetite seeking higher returns. About $70 billion in corporate bonds have been issued in February, up from $21.4 billion in October, but still only about half the level of last May, according to Thomson Reuters. However, the corporate bond market, where big companies go to raise capital -bypassing banks, are drying up quickly as well.

Conclusion

Indeed, the era of excessive spending and debt is over. For now, a quick resurgence in inflation is only a remote possibility. There is nevertheless a possibility, considering that central banks tend to have a hard time knowing when to take the punch bowl of “excess liquidity” away. The banking system remains crippled. Lending standards are high and are not coming down, as banks work to lower their leverage ratios from 30 to the low teens. An economic recovery will be unlikely until producers exhaust their existing capacities. Debt levels are so high that any increase in interest rates will impose a significant burden on consumers and the economy, thereby stunning growth.

On the other hand, in a near 0% interest environment, investors will need to take more risks to garner higher returns. It's also unlikely that the stock market can keep up a 9%-a-year average return as asset values stay depressed. So the wealth effect is not going to be increasing any time soon.

Therefore, the near term inflation concerns are overblown, as we are still in a deflationary environment. Unlike Yellen, who projects stagnation for the next 2-3 years, I could envision the scenario playing out for the next 18 months. In my opinion, any stagnation projections beyond 18 months are highly speculative, and reliant upon too many unknowns to be reasonably considered at this time.

Source: Yellen's Stagnation View: A Real Possibility?