There’s a new concern to add to Wall Street’s growing list of worries about the economic recovery: that the U.S. could slip into a scary deflationary spiral, a development that would inflict serious pain on the economy.

While there are a number of contrarian indicators suggesting deflation is not imminent -- such as soaring gold prices -- yields on benchmark Treasuries this week have some saying the bond markets are bracing for deflation, a sinister development marked by an across-the-board price decline on goods and services.

Most economists aren’t yet losing sleep over the decimating impact of deflation at this point, and hopefully they never will; steep deflation is a rare phenomena in the U.S. and economists aren’t exactly sure how to deal with it.  

“It would be a period of essentially stagnant economic growth. It would be a disaster for the U.S. economy,” said Gus Faucher, director of macroeconomics at Moody’s Economy.com.

Is Deflation Really in the Cards?

For the clearest sign of trouble, the deflationary camp points to the yield on the benchmark 10-year Treasury note falling below the 3% level this week for the first time since the financial crisis of 2008.

“That’s an indicator to me that the smart money, which I consider to be the bond market money, is preparing for the worst. It’s not necessarily predicting a double-dip recession but some kind of deflationary spiral,” said Scott Martin, managing director at Astor Asset Management. “There is no inflation in sight and, in fact, deflation is here.”

The Institute for Supply Management’s latest manufacturing report, unveiled Thursday, offers some troubling pricing signs, with the index’s prices component tumbling by 20.5 points to 57 in June from the month before. While still increasing (above 50 indicates expansion), the pricing index suffered the steepest drop out of all of the report’s components. Among the industries reporting price declines were wood products, primary metals, machinery and transportation equipment.

It may be an overstatement to say deflation has already arrived, but the latest read on consumer prices in the U.S. does appear to set off more alarms about deflation than inflation. The consumer price index, which excludes volatile food and energy prices, was up just 0.96% in May and April each, marking the lowest annual increases in 47 years. Inflation at the consumer level was off 0.2% in May from the previous month -- the steepest monthly decline since December 2008.

That's a good example of disinflation, which occurs when prices for goods and services are still growing, but the pace of increase slows. Deflation, on the other hand, occurs when prices outright decline due to poor demand and a deflationary spiral refers to steep deflation that gets out of control, similar to what the Japanese experienced during their "lost decade."

“This is considered to be very dangerous and bad for the economy because if the expectations that prices are going down are set into consumers or businesses, you will start delaying your purchases. What you buy tomorrow will be cheaper than what you buy today,” said Adolfo Laurenti, chief economist at Mesirow Financial.

Essentially, all asset classes would be worth less in a deflationary spiral, meaning the stock market would fall sharply, home prices would tumble further and Americans’ savings would depreciate.

“It would be worrisome for people if they see prices are falling, asset values are falling and there is no indication it’s going to end any time soon,” said Faucher.

Difficulty in Fighting Deflation

A deflationary spiral is also scary because it really hasn’t happened to the U.S. economy since the 1920s during the Great Depression, raising concerns about whether policymakers would know how to fix it.

Economists say the government would likely have to resort to more fiscal stimulus to make up for the loss of demand, yet there is little to no political will right now for more government spending due to high deficits and debt woes in Europe. On the monetary side, the Federal Reserve already has interest rates nearly as low as they go, leaving it without its key tool for spurring growth and demand.

“The real problem (with deflation), like inflation, is that it’s in the mind of the people. You have to use policy tools to change perception, which is very difficult,” said Laurenti, comparing it to former Fed chief Paul Volcker’s unpopular efforts to beat back inflation in the 1980s.

What About Soaring Gold?

To be sure, most economists don’t believe a deflationary spiral is in the cards, and -- for the most part -- the markets don’t seem to be pricing it in either. Even though the Dow Jones Industrial Average suffered its worst second quarter since 2002 and ended Wednesday at seven-month lows, it still remains more than 3,000 points above its bear-market bottom and appears more worried about a slower recovery than a deflationary spiral.

Economists point to positive productivity and excess liquidity in the economy as indicators that deflation isn’t likely at this point.

Plus, gold, which is seen as a hedge against inflation, jumped to an all-time high as recently as June 18 and surged 11.9% last quarter, its biggest quarterly rise since the final period of 2007.

“You have gold saying we’re living in inflation and the 10-year saying deflation. They both can’t be right,” said Art Hogan, chief market strategist at Jefferies & Co. “Somewhere in the middle is probably going to be right.”

Just like during the financial crisis, the yield on the 10-year note falling below the 3% mark is more likely an indication of the risk aversion on Wall Street than of a deflationary spiral. Fearful about the economy, cash has been flooding away from risky assets like stocks and commodities and into relatively safe U.S. bonds.

Ultimately, Faucher and Laurenti both say they see just a 10% chance of the U.S. becoming ensnared in a painful deflationary spiral. However, Laurenti sees a 20% to 30% chance of deflation occurring in the U.S., and he’s not entirely sure about the implications.

After all, the Fed is typically comfortable with moderate inflation of about 2% to 3% and only begins to worry when it rises about that level. “We learn to live with mild inflation… so I wonder if that might not be the case with deflation,” said Laurenti.  

However, “even if in theory we could live with moderate deflation, nobody is willing to take a chance. We prefer the bad we know to the evil we’ve never really explored,” he added.