Submitted by Lance Roberts via STA Wealth Management, Earlier this year I wrote two articles about the Fed's ability to hike interest rates this year. (see "Fed At Risk Of Missing Window To Hike Rates" and "The Window Continues To Close.") In both articles, I discussed the biggest worry of the Federal Reserve, and frankly every Central Banker on the planet, was deflation. The problem with deflation, as an economic pressure, is that once entrenched it becomes extremely difficult to break as conventional monetary policy tools, mainly interest rates, have little effect. The Federal Reserve has continued to hope for the last several years that extremely "accommodative" monetary policy, near zero interest rates, would spark stronger levels of economic activity leading to a rise in inflationary pressures. Unfortunately, this has yet to be the case. This is likely due to a monetary policy phenomenon known as a "liquidity trap" which is described as follows: "A 'Liquidity Trap' is a situation described in Keynesian economics in which injections of cash into the private banking system by a central bank fail to lower interest rates and hence fail to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels." The problem for the Federal Reserve is that getting caught in a liquidity trap was not an unforeseen outcome of monetary policy, but rather an inevitable conclusion. As shown in the chart below of GDP, inflation and interest rates, each time the Fed has intervennd with monetary policies it has lead to lower rates of economic growth and lower rates of inflaton and interest rates. As stated, the current low levels of inflation, interest rates, and economic growth are the result of more than 30-years of misguided monetary policies that have led to a continued misallocation of capital. For several years, there have been repetitive screams that inflation was imminent due to deficits, a fiat currency and expanding debt levels. Yet, the opposite has been true. The lack of inflation has been a construct of the underlying structural dynamics of the economy. Home ownership rates have plunged, technological advances and productivity increases have fostered wage suppression, and high levels of uncounted unemployed (54% of the 16-54 aged labor force) drag on economic strength. The exceptionally low yields on government treasuries are clear evidence that inflation is not a threat. For all the money that has been spent trying to ignite the engine of economic growth; it has all remained a futile effort at this point. Now, after more than six years of an economic expansion, interest rates remain near zero, and the velocity of money continues to plummet. Velocity Of Money The velocity of money is defined by Wikipedia as: "The average frequency with which a unit of money is spent on new goods and services produced domestically in a specific period of time. Velocity has to do with the amount of economic activity associated with a given money supply." As the velocity of money accelerates, demand rises and inflationary pressures increase. However, as you can clearly see, the demand for money has been on the decline since the turn of the century. The surge in M2V during the 90's was largely driven by the surge in household leverage as consumers turned to debt to fill the gap between falling wage growth and rising standards of living. (For more on the problem with incomes read "The 80/20 Rule.) The problem with wage deflation for the Fed is for wage growth to occur, the economy really does need to approach "real" levels of full employment. As the supply of labor shrinks, the demand for wage increases occurs. The problem is that with uncounted masses of individuals residing in the shadows, the demand for labor is swamped by the demand for jobs which suppresses wages. The issue for the Fed is that the decline in the "unemployment rate," caused solely by the shrinking labor force, is obfuscating the difference between a "real" and "statistical" full employment level. While it is expected that millions of individuals will retire in the coming years ahead; the reality is that many of those "potential" retirees will continue to work throughout their retirement years. In turn, this will have an adverse effect by keeping the labor pool inflated and further suppressing future wage growth. Double-Digit Imported Deflation But there is more to the deflation story. More than six years after the last recession, deflation remains an imminent threat not just domestically, but globally. The Eurozone, Japan, and even China are all wrestling with slowing economic expansion despite success rounds of interventions and accommodations. The collapse in commodity prices, interest rates and the surge in the dollar are all clear signs that money is seeking "safety" over "risk." The Economic Cycle Research Institute (ECRI) recently published a very interesting piece on the potential for double-digit imported deflation in the U.S. To wit: "Even worse is the nosedive in yoy import price growth, which has been exhibiting double-digit deflation since the beginning of the year (bottom line). Indeed, the only other time on record the world has seen such intense import price deflation was during the global recession." But here is the important conclusion: "From our cyclical vantage point, we have long been aware of the truism that recession kills inflation. Therefore, when the next recession arrives, it is more likely to push inflation below zero at a time when the Fed has no obvious policy response. The resulting deflation would be the stuff of policy nightmares." The Window Has Closed It is becomingly increasingly clear from a variety of inputs that deflationary pressures are mounting in the economy. Recent declines in manufacturing and production reports, along with the collapse in commodity prices, all suggest that something is amiss in the production side of economy. While the Federal Reserve should have chosen to increase rates long ago, which such tightening of monetary policy would have been somewhat offset by continued floods of interventions. However, the Fed is now trapped in a difficult position as I addressed previously: "The Federal Reserve has a very difficult challenge ahead of them with very few options. While increasing interest rates may not "initially" impact asset prices or the economy, it is a far different story to suggest that they won't. In fact, there have been absolutely ZERO times in history that the Federal Reserve has begun an interest-rate hiking campaign that has not eventually led to a negative outcome. While the Federal Reserve clearly should not raise rates in the current environment, there is a possibility they will regardless of the outcome. The Fed understands that economic cycles do not last forever, and we are closer to the next recession than not. While raising rates would likely accelerate a potential recession and a significant market correction, from the Fed's perspective it might be the 'lesser of two evils. Being caught at the "zero bound" at the onset of a recession leaves few options for the Federal Reserve to stabilize an economic decline." For Janet Yellen, the "window" to lift interest rates appears to have closed. As the ECRI correctly concluded, this could potentially be a policy nightmare for the Fed, the economy and you.