Tuesday, October 13, 2009

Inflation or Deflation?

It seems like I keep coming back to this theme - are we in for Inflation or Deflation? In past blogs I've argued for both and favored the Inflation view. I'd like to update you on my current thinking, which is to say I still don't know the future and the present is getting tougher and tougher to figure out. I like to style myself as somewhat contrarian, thus when I was buying TIPS (Treasury Inflation Protected treasury bonds) back in November when everyone else thought we were entering a deflationary cycle, yields were over 3% real. I've written a lot about the printing presses of the Federal Reserve and the devaluation threats we face with a currency that is overleveraged and increasingly increasing in the amount available. I've stated that Inflation is the real threat. I still believe inflation is a huge threat, however the consensus view has now changed to agree with me and that makes me question whether I am right. Its not that the consensus is always wrong, its just wrong often enough to scare me when I'm in the consensus.

So here is the Inflation story in a nutshell:

The Federal Reserve is printing money faster than at anytime in history (that I'm aware of)

That printing of dollars leads to more dollars, whenever you have more of something it is worth less

Worth less dollars quickly become "worthless"

$1 in 1800 would buy you MORE in 1913 (50% more) than in 1800, In 1913 the Federal Reserve was created and today the dollar buys 99% less (its worth the equivalent of 8 cents in 1800 dollars, I say 99% percent because the dollar peaked at $2.04). See Sean Malone's Rise and Fall of the Dollar

We have a history (other than the Great Depression) since the Federal Reserve was created of inflating our currency.

The United States is in a debt spiral, our National Debt is approaching $12 trillion, or annual deficit will be $1.6 trillion this year and our off-balance sheet debt is between $50 and $105 trillion depending on who is counting it.

With all this debt there is no choice but to inflate the currency and "inflate our way out of this mess"

Essentially this is the conventional wisdom. I actually believe most of this and think that long term, inflation is a huge threat.

But what of deflation? Are we seeing inflation right now?

Gas prices are going up, but are still lower than a year ago

Home prices are lower and despite what the media says, going lower or stagnating

Restaurants haven't raised prices and I'm getting much better deals when I go (I see more Happy Hour's!)

Cars are not significantly cheaper, but they aren't rising in cost (okay, they were cheaper when subsidized with Cash for Clunkers)

My Internet, Cable and Phone are cheaper and I have more services

Wages are not going up, they are dropping and people are taking pay cuts or forced furloughs (or being fired)

Airline tickets are not higher (even with higher oil prices)

Hotel prices are not higher, they are much lower in some cases

My point? We are now experiencing deflation, despite the best efforts of the Federal Reserve. The only place we see inflation is in commodities and asset prices (Gold, Stocks, etc). Right now deflation is winning. If you're looking for a model where a country printed lots of money and didn't experience inflation......look no further than the second largest economy in the world - Japan (for now at least).

How could we have deflation with so much money being printed? The money is not being put to work. There is a tremendous demand for safety right now and U.S. citizens are putting their money into banks, who are not lending the money out (which creates reserves and excess reserves). This huge demand lowers the amount of interest a bank must pay (supply and demand always win out).

What many are leaving out of the inflation debate about printing money is Velocity of Money. Though some recent research points out that its the banks creating money, not the federal reserve that leads to excess reserves and more Fed printing, I'm not yet convinced. Here is the simple explanation. The Fed prints money and that money sits on deposit with the banks, but if the banks don't lend that money out (which they are not because their balance sheets are impaired and they are scared of the marketplace right now (self-fulfilling prophecy)) the money doesn't circulate and multiply. Velocity is simply a measurement of how often a dollar gets recylced through the system. If an individual applies for a loan to buy a car and that loan is granted then $30,000 is lent to buy the car and is deposited into another banks account, creating new money (this is called fractional reserve banking), if that bank decides to lend that money and there is a borrower worthy, the money continues to circulate and more and more money is created (sounds weird and my explanation is terrible). The point is that if people aren't spending and if banks aren't lending, there is no velocity and thus no leveraged money creation.......no inflation.

To be fair, the inflationists (of which I am one, but I'm also a deflationist....how do you like that!) don't believe we are in an inflationary cycle now, but that if banks become more confident and put those excess reserves (which are massive) to work and start lending again we could see a bubble even bigger than before as banks routinely will leverage themselves by a factor of 12 - 20 (meaning that for every $1 the Fed creates, the banks turn it into $12 or $20), this would lead to mass inflation.

If you're confused, don't worry, you are supposed to be. The government and Federal Reserve have set up a system that is absurd and the more you don't want to know about it, the easier it is for them to get away with just about anything.

Many will argue that the Fed's goal is to inflate our way out of this massive debt we've accumulated and they are right to an extent. China is nervous as are other countries which is why the dollar has been falling, but make no mistake, the dollar is still king....for now. In a panic, people will clamor for dollars (unless of course that panic is induced by a mass devaluation). Believe it or not the $12 trillion is not our biggest problem. A problem it is and it must be addressed, however the real problem is the one that CAN'T be inflated away - Entitlements. Social Security, Medicare and Medicare Part D (not to mention Medicaid) are REAL obligations, meaning that the value can't be inflated away - the only way to reduce these deficits is to raise taxes (by a lot) or reduce benefits (actually technology can also reduce these costs.....as well as increase them).

We have a huge debt problem and if not faced head on and soon, it threatens our way of life and that of our children and grandchildren.

We are in a depression right now and deflation is winning the day. How long this will last, I don't know, but we need to be prepared for both scenarios.

Scott Dauenhauer CFP, MSFP, AIF