In this edition of C|A Answers, two members of our research team debate the potential for persistent deflation in the United States.

Sean McLaughlin: No. The recent dip into deflation for the “headline” US Consumer Price Index (CPI) is likely to be short-lived and does not significantly increase the likelihood of persistent deflation. Headline inflation in January fell slightly on a year-over-year basis (-0.1%); however, the 35% drop in gasoline prices accounted for a stunning -1.4 ppts of the headline total. Core inflation, which strips out volatile food and energy prices, registered a 1.6% increase. And the impact of the fall in gasoline prices will move through this year: if gas prices remain at today’s low levels, the year-over-year impact on headline CPI will begin to decrease and would disappear by next January. There are good reasons that the Federal Reserve pays little mind to the headline number.

Also transient: the impact US$ strength has had in holding down prices of imported goods (think Japanese- and German-manufactured cars for example, and the respective 13% and 16% decreases in the yen and euro for the 12 months ended in January). The negative impact of the yen and euro on headline US inflation will begin running out of steam this year unless the currencies slide further. The bottom line is that the recent deflation seen in headline CPI is not particularly meaningful when thinking about the risk of persistent future deflation.

Even if today’s deflation is not likely to be meaningful, are there reasons to worry about deflation? Certainly, as my colleague Eric Winig lays out below. However, investors should ask themselves: five years ago, were they positioned for utterly flat prices over the next five years, or like most investors were they instead concerned about a potential inflation outbreak? In early 2010, five-year TIPS breakevens were at 1.9%, vastly ahead of the 0.1% realized inflation that occurred over the next five years. It was easy in early 2010 to make the case for medium-term inflation, but that outcome did not pan out.

Rather than positioning portfolios for persistent deflationary conditions in the United States, investors should construct portfolios that they believe will be as resilient as possible in both inflationary and deflationary conditions. Forecasting inflation is fiendishly difficult. Last June, ten-year breakeven inflation hit 2.3%, and by year-end it had plunged to 1.7%. What changed over that period? Non-dollar currencies and oil prices fell, of course, but those two factors are unlikely to impact purchasing power over the next ten years by a cumulative 7 ppts, as bond price changes imply. So, investors that are somehow confident that they know the level of future inflation should feel free to position aggressively for that outcome. Those lacking a crystal ball should pack both an umbrella and a bathing suit.

Eric Winig: I agree with Sean that the US CPI’s dip into negative territory is much ado about nothing, though I believe the number is emblematic of powerful deflationary forces that continue to press down on the global economy. First and foremost is the remarkable increase in debt that has occurred since the global financial crisis, despite near-constant chatter about “austerity.” According to McKinsey, total global debt since 2007 has increased by a whopping $57 trillion, or a full 17 ppts relative to global GDP. More debt is of course inherently deflationary—proceeds do bring forward consumption, but future interest (and principal) payments suck capital out of the economy. (Or the debt defaults. Which is also deflationary.)

In the United States specifically, economic data have shown unexpected—and in some cases dramatic—weakness in recent months, even as many seem convinced the US economy has turned a corner to self-sustaining growth. Citigroup’s US Surprise Index, which tracks economic data relative to expectations, recently fell to a two-and-a-half-year low. Indeed, the majority of economic data points released in February were below expectations, including such big-ticket items as retail sales, existing home sales, and factory orders. Most recently, the ISM Manufacturing Index hit its lowest level since January 2014, also known as the “polar vortex” month when economic activity fell off a cliff.

Still, a number of people continue to anticipate rising bond yields and higher (but not too high) inflation stemming from an economic recovery. While Sean is correct that no one knows the future course of inflation, many of these hopes—for both economic growth and higher inflation—are based in large part on fundamental misunderstandings about the Fed’s recently concluded QE program. QE, for all the attention it received, was a very pedestrian affair. The central bank simply bought Treasuries with cash … which for the most part stayed at the Fed as “excess reserves.” While this did force interest rates lower as it boosted demand for Treasuries, it had little to no impact on consumption or bank lending.

So why do so many continue to look to QE (and its aftereffects) to generate higher growth and inflation? Well, former Fed Chair Ben Bernanke laid out the rationale in a 2010 Washington Post op-ed, where he predicted lower rates would encourage mortgage refinancing and corporate borrowing (although he didn’t note that much of this would be spent on share buybacks), but then got to the meat of the argument: “higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

We got the higher stock prices, and consumer confidence has recently hit post-crisis peaks, although it has since pulled back a bit. Yet the economy remains sluggish. Why? As Lacy Hunt of Hoisington Asset Management recently put it, “there’s really nothing that monetary policy can do, and the fact that inflation in the US is substantially lower than when all of these quantitative easing efforts started is an indication that such policies are a bankrupt effort.”

I couldn’t have said it better myself.

Sean McLaughlin and Eric Winig are Managing Directors on the Cambridge Associates Global Investment Research team.