Wednesday, March 24, 2010

Potential __flation Scenarios

Perhaps the biggest debate in economics today is between the inflationists and deflationists. I have covered this over the past few years with relatively little additional insight as to which we will have and when (yes, I am partially dissing myself). What I'd like to do is present a few scenarios of what could happen.

If you've watched just about any financial or political television or talk radio you've no doubt heard of the massive amounts of money being printed by the Federal Reserve to buy certain assets. The commercials for Gold are about as prevalent as the mortgage commercials were a few years ago. You see chalk boards and charts showing the Fed's balance sheet ballooning in an almost parabolic manner. These charts are correct, the Feds balance sheet has grown in an unprecedented manner and the printing press continues. All of this money printing must lead to inflation, correct?

Not necessarily, at least not right away.

As I've spoke about in the past you need more than money printing to create inflation, you need that money to circulate and right now it is not. The money is actually going to prop up the massively deflated balance sheets of our nation's financial institutions (who claim that they are solvent). Let me give you an example of what I mean. Let's pretend that I own a printing press and have been given permission to print money. I decide to print up a bunch of money and give it to you in exchange for perhaps your house. I've printed money and increased the money supply, but if you don't spend that money it doesn't create inflation. Lets say you take that money and put it in a tin can in your back yard - no inflation. This is of course a highly simplistic explanation of the Velocity of Money, but in essence what is happening right now is that the Fed has created a lot of money, but the banks are not lending it out and thus it is not getting into circulation and being spent. No circulation, no inflation from the money printing. This doesn't mean there won't be inflation, just that the inflation could be caused by other events or that eventually the banks will begin lending this money and create an inflationary boom. With no bank lending, there is little that this Fed Balance increase will do to create inflation.

The reality is that we could (I said could, not would) see deflation occur. If you don't believe me just take a look around - its not easy to get a raise, its not easy to get a job and people have less money to spend. People are saving more, they are walking away from their houses and state and local governments are having to cut, cut, cut while raising taxes (taking money out of the consumers pocket). Tax revenues are not increasing, they are falling and it is this type of deflation that could eventually lead to a hyperinflation outcome. In fact, research that I've read shows that hyperinflation events almost always occur because of deflation that leads to massive fiscal deficits that can only be solved by a central bank printing money. This money printing gets into the economy because it is used to "monetize the debt", essentially becoming government spending which leads to inflation, higher interest rates and larger fiscal deficits which leads to more money printing and a downward spiral.

Yet another scenario is that we get inflation and deflation at the same time (I'm talking about personal inflation/deflation, not inflation/deflation as it applies to the money supply). If you think about it, nobody experiences CPI (Consumer Price Index) inflation. Everyone experiences their own inflation rate (which in some cases is simply supply/demand imbalances, other times bubbles, still other times both). If you grow your own food, travel very little and own your home outright - there is not much inflation can do to you (save perhaps higher water and heating bills.....pretend you live in a moderate climate!). Lets say that you live in a dense metropolitan area where home prices are high and so you have to commute a long way to work, if oil prices rise you are in trouble as it affects everything you do. The price to commute goes up, the price of food goes up...etc. Health care costs affect people differently depending on their relative health. We could have a major inflationary event and some people would not be hurt, while others would be dramatically affected. Major components of the CPI could be rising in price while other major components are falling - offsetting one another, but the effect is the same for those who need the components that are rising in price.

Another scenario, one that is becoming more likely do to the utter ignorance and stupidity of our nations banking system is where the banks decide that they are comfortable making loans again and begin making stupid loans - lending out all those reserve and creating another bubble that leads to inflation, higher interest rates and a bigger crash than in 2008. All of this could take many, many years to play out (look how long the real estate bubble went on for).

So what do I think will happen?

This is tough, there are too many variables to make an accurate prediction, but my gut tells me that we will first see deflation, followed by another dose of extreme measures which may lead to the inability of congress to continue their spending without much higher interest rates and/or Federal Reserve direct monetization of the deficit. This could take several years to play out.

If you don't believe that we could have deflation, look no further than our Federal Reserve's current Zero Interest Rate Policy. If we were actually growing and stabilizing wouldn't it be criminal for the Fed NOT to raise rates? Yet the Fed has no confidence in the recovery and fears deflation which is why they are keeping rates at zero and CAN keep rates at zero. What the Fed says and what the Fed is doing are incompatible, the question remains how this will resolve itself.

I'm not sure I've provided any more clarity about the future (mainly because I have some difficulty predicting it!), but perhaps I've shed some light on possible scenarios.

Oh, one more scenario - the dollar remains strong with no inflation or deflation and we continue to spend unlimited amounts of money because all the other countries currencies are so much worse (this is perhaps the scariest of all, except that it could lead to a sustained boom that masks all underlying issues).

Scott Dauenhauer CFP, MSFP, AIF