There has been a pervasive idea in the financial industry, for years, that interest rates are likely to rise soon because there is not much room for them to fall, which seems logical but may only be possible after a deleveraging cycle that could potentially push interest rates even lower, due to further debt-based economic stimulus, deflation expectations, and/or a demand for safer assets. When high debt levels occur simultaneously with languishing incomes and low economic growth, a temporary rise in interest rates may have a downward force on the broad economy as higher interest repayments on already high debt loads inhibit consumer spending and economic growth. This encourages a deleveraging cycle with deflationary effects. Essentially, the U.S. government and the average U.S. consumer cannot afford higher interest rates due to high debt levels and stagnant income levels.
Although higher rates may be likely at some point in the future, consistently higher rates may not be possible for several years, and it may be more likely that the economy’s growth is slowly eroding due to unproductive debt burdens, pulling the country into a deleveraging and deflationary phase. Because of the Fed’s inability to influence interest rates lower and the ineffectiveness of experimental monetary policy (large scale asset purchases (LSAP) and negative interest rate policy (NIRP)) to affect the broader economy the deleveraging phase may be a very uncomfortable adjustment period.
A severe deleveraging and deflationary cycle would most likely call for further stimulus programs including unemployment support, which would increase government debt, potentially cause currency debasement, and possibly result in inflation after the deleveraging process occurs. Sustainability of U.S. government debt may be called into question if inflation takes hold after a consumer-deleveraging phase where a significant movement of private debt to the public balance sheet occurs.
Inflationary and Deflationary Effects
ZIRP and LSAP both have inflationary effects but debt repayment and debt default have deflationary effects. Stimulus programs have inflationary effects that are canceled by the deflationary effects often seen inside a recession. While price inflation may be seen in certain goods and the prices of certain assets, deflationary forces may be seen in others such as the velocity of money, which has been trending down since 1997.
The velocity can slow under extreme indebtedness, when debts are not productive, or under weak aggregate demand. Hyman Minsky observed that debt must be able to provide an income stream to repay principal plus interest for the debt to be considered productive debt. If the income stream generated by the debt does not cover principal plus interest, the debt becomes more burdensome and either more debt would be needed to make the payments or default would likely occur. As debt levels increase so does the risk that it will not be able to create an income stream to repay the principal and interest. One should watch velocity of money, debt levels, incomes, and commodity prices to see whether broad inflation will emerge.
Inflation is a possibility due to continued government stimulus that may be increased in other non-LSAP forms if a severe deleveraging process does take place; but inflation is typically seen to lag stimulus programs and would be more likely after a deleveraging process.
Temporary inflationary forces might even cause the deleveraging process to unfold; a spike in commodity prices due to commodity shocks would cause a larger portion of already stagnant incomes to be swallowed up by rising prices on staple items such as food and energy, inhibiting consumer spending and possibly inciting consumer debt default. Commodity demand seems to be falling on aggregate as seen in commodity prices since 2013, but price spikes could be possible due to supply constraint.
While a global shock or global recession might encourage a general risk-off environment, which may favor the U.S. dollar, government stimulus in response to a severe deleveraging process could potentially set up a long period of U.S. dollar erosion.