I. Introduction: Inflation v. Deflation
I have received a few emails and direct messages on twitter regarding my take on the now hot button issue of whether inflation or deflation is presently the most pressing threat to the American economy. If you are wondering why I say that this issue has become so contentious, just check out this clip featuring Rick Santelli and Ron Insana duking it out on CNBC last Friday. Before I delve into my arguments, let me make a few points upfront. Make no mistake, this piece has nothing to do with what the Federal Reserve and the federal government should or should not have done. Rather, I am focusing on what has actually been done, and the ramifications thereof. Also, the performance of the precious metals should be taken with a grain of salt, as they have historically performed reasonably well not only in times of inflation, but also during deflationary periods as well.
II. The Other Side of the Mountain
First and foremost, those who simply point to zero interest rates and all of the money printing and federal deficit spending by the Federal Reserve and the Legislative and Execute Branches of the federal government, respectively, as inflation per se are missing a critical issue. That is, the zero interest rates and all of the quantitative easing and stimulus spending have been done in an attempt to try and combat an enormous amount of money that has been destroyed.
Over the past several decades, the availability of easy credit has allowed individuals, households, corporations, as well as governments around the world to borrow against the supposed growth of the future, in order to spend freely in the present. This all works well when, for example, house prices appreciate in a seemingly perpetual manner. When future growth becomes so complacently assumed, consumers can buy three or four houses with no money down, and then turn around and get a home equity loan to spend like a rockstar. Eventually, when the party ends, house prices cease to rapidly appreciate, more realistic expectations about future growth start to set in, and credit begins to contract. When this happens, an enormous amount of supposed wealth will naturally be destroyed. House prices will crash, and consumers and small businesses will have a much tougher time getting credit.
III. Inflation is Desperately Trying to Play Catch Up
The issue of whether the money printing and federal deficit spending will lead to imminent inflation is a lot like asking whether world-class swimmer Michael Phelps will soon become an obese, unhealthy man. Two summers ago, in the midst of his incredible string of medals at the Olympics in China, the media focused a good deal of attention on the young swimmer’s diet. He would regularly eat three fried-egg sandwiches, along with three chocolate chip pancakes, one five-egg omelette, a bowl of grits and three slices of french toast, all loaded up with goodies. And that was just for breakfast!
If one had simply looked at his diet in a vacuum, without knowing anything else about who he was, the easy answer would be to readily assume that Phelps was an obese person, even if he did not have health problems. He regularly consumed tons of calories from fatty foods. Similarly, if one looked at the zero interest rates and all of the federal spending in a vacuum, it would also be very easy to simply scream,”Inflation, inflation, inflation!”
However, there is more to the story. Michael Phelps regularly consumes an exorbitant amount of calories because he is a young, muscular male with a high metabolism, who vigorously trains many hours per day. In essence, his diet is trying to “play catch up” to the amount of calories that he is burning through training, as well as (presumably) the amount of calories he is burning naturally with his metabolism. Likewise, the Fed and the federal government have been trying to “play catch up” to the amount of perceived wealth that has been destroyed through the bust of the credit bubble. Sure, spending a few trillion dollars sounds atrocious to a law-abiding, tax paying citizen of America. However, keep in mind that the amount of perceived wealth that has been destroyed, worldwide, is estimated to be somewhere around twenty trillion U.S. dollars.
Thus, as eye-popping as Michael Phelps’ diet is, he is still “in the hole,” playing catch up to the amount of calories that he burns every day. Need proof? Just look at his lean and wiry body. Similarly, the Fed and the federal government–as egregious as their printing and spending measures may seem–are still deep in the hole, trying to play catch up to the amount of perceived wealth that has been destroyed. Thus, deflation is by far the stronger force, just as with Phelps the amount of calories he is burning overpowers whatever mind-boggling amount of food he eats every day. Need proof? Just look at the bond market, notably the 10-Year.
IV. Nothing Lasts Forever
Thus far, I have presented the view that deflation is the clear theme in society today. Notice that I am not calling it a “threat” like many others are. It simply it what it is. Risk is being repriced in a much more rational way, despite how painful it may feel to some. Perceived wealth has been destroyed, home prices have cratered, unemployment is high, and consumers continue to retrench. While some corporations have done a good job of keeping their balance sheets clean, many big banks are still, essentially, insolvent zombies. Moreover, those healthy corporations with stockpiles of cash are more or less sitting on that cash, like a dog hiding a stash of delicious food to be put to good use at a later date. In my view, all of the above factors point to deflation.
However, nothing lasts forever. Eventually, at some point in the future, Michael Phelps’ metabolism will slow down as he grows older, and his workouts will become infrequent and less intense. If he continues to eat the diet that he currently does, there is a high probability that he will become obese and possibly have health problems. Simply put, the amount of calories that he takes in will begin to exceed–and possibly greatly exceed–the amount of calories that he is burning. If he is not quick in adjusting his diet, he will see a sharp weight gain in a very short amount of time.
Likewise, with America’s newfound high savings rate, more and more consumers will eventually become creditworthy again. Individuals and households will eventually emerge from a painful deleveraging process with far better balance sheets. Further, the rate of credit and wealth destruction will slow and eventually turn up again. When this happens, the velocity of money in our society will begin to pick up. The bond market will start to reflect the idea that merely a marginal return on capital will be insufficient to keep pace with higher expectations of inflation. When this happens, if the Fed and the federal government do not quickly adjust their policies, we could easily see a very sharp spike in inflation in a short amount of time. If history serves as our guide, the Fed and the federal government are not likely to adjust their policies in a well-timed manner.
V. Conclusion: It’s All About Timing
All of the machinations by the Fed and the federal government are desperate attempts to combat a vicious deleveraging process. Inflation is not the issue today, and in fact it is not likely to be the issue of tomorrow. Instead, a more constructive way to view inflation would be consider it as the last chapter in a long and dramatic novel, to paraphrase Hugh Hendry. For now, deflation remains at front and center. The argument that “the Fed has the printing press, and therefore we cannot have deflation” is misguided because it fails to consider: 1) How big of a deflationary hole we are in, and 2) The lack of velocity of money in society today, given very tight credit and a shift towards savings rather than free-wheeling spending without regard to one’s balance sheet.
Eventually, that will change. However, that change could just as easily take a few decades to materialize, as it could a few years. In the short term, any spike in inflationary expectations should probably be viewed as a head fake that will set us up for the next deflationary leg down, just as we saw in 2008.Twitter