Predictions for the Coming 'Flation'

Flation is not a word, but it is the suffix of both inflation and deflation. Ruling out the middle ground, I’d say it’s very likely that we will see one of the two in a large way during the next few years.

Over the last half year, we have seen massive deflationary forces take hold of our economy and the economy of the world. These forces were so strong that they eventually destroyed what many of us thought was a sustainable commodities appreciation, and turned the economies of the world upside down. With no end in sight for the near future, many people are assuming that we will be in this downward deflationary spiral for a long period of time. Those that don’t believe this theory holds water believe that, due to the Federal Reserve’s actions, we will see a long period of rapid inflation.

I’d like to present a different theory that I believe will be a more accurate prediction of the future. The current state of the world economy is extremely complicated because so many of the models we had relied on for many years proved to not be as infallible as previously thought. Many people were caught in this “black swan” type trap, but the important thing going forward is to think rationally in order to determine the most probable future.

One of the biggest “truths” that we used to hold was the way we thought about monetary policy. As we were all taught in our economics courses, whenever the Federal Reserve increases the monetary supply by lowering their target for the federal rates, we should expect this action to have an inflationary effect under normal circumstances. Historically, this has been true… and for a large part of 2008, this did in fact occur. Recently, however, we have seen a shift in this philosophy. Ben Bernanke and the Federal Reserve have continued to slash their target for the Federal Funds Rate, but during this time period the backs of oil, gold, and all other commodities were broken.

On top of this, the real estate market, equity market and debt market also collapsed. Massive deflation occurred, and Bernanke, the student of Japan’s decade long deflation, answered by lowering the Federal Funds Rate to a historic low of a 0.00% to 0.25% range.

Naturally, this did not have the desired effect for two reasons. First, anyone who was paying attention to the Federal Reserve knew that Big Ben had been ignoring his own target by allowing the Federal Funds Rate to slip down to this level for more than a month ahead of the “official” rate cut announcement. This was only big news to the people that trade and invest on every CNBC’s commentators’ word, not to the intelligent investors of the world. The only effect that this announcement had was a shift in the psychology of the average investor, which leads me into the second and more important point.

Ben Bernanke followed his Japanese case study to a T, but there was one variable that was not present in the Japanese “lost decade” that is the driving factor of the current deflationary environment we are experiencing: confidence, or more accurately trust, is no where to be found. Formerly liquid markets are no longer so liquid… and even the largest and oldest of banks no longer trust each other. This “freezing” of the financial markets more than negated Helicopter Ben’s actions. What Bernanke failed to understand was that no matter how long you keep the printing presses running… all of that money sitting in vaults (or now in most cases electronically) in banks is depreciating in value; this is something that he does not have the power to fix. This is like trying to fight fire with fire. In essence, he is only making the coming problems much worse. Unless Bernanke can change the mindset of the banks, he has almost no power. These banks are using the TARP (Troubled Asset Relief Program) money to pay down debt, de-leverage and strengthen their balance sheets & Tier I capital. I can assure you that the first concern of the banks is not to fix the United States liquidity problems to help out Big Ben.

The problem with Bernanke’s actions is that someday in the future, confidence, and in turn demand, will be regained (this could be a while) and there will be too many banks with war chests that are far too large. We have already seen the first part of the cycle occur with rapid deflation, but the second part includes rapid inflation that will be uncontrollable. No one will know when this shift will take place, excluding possibly the heads of all of the large banks. When they decide to make this money available for use, we will see inflation problems that will make the price increases of this summer look very tame in comparison. In the mean time, no one will be spared, not even in hot sectors like information technology.

Many naysayers will question my predictions and ask how in the world I could even consider inflation a possibility at this point in time. I would contend that things aren’t always as the media would portray them. Rational and experienced investors know this ”obvious” prediction to be flawed, but it’s hard NOT to question your beliefs when 90% of the population believes otherwise. The key here is to stay the course and not to be sucked into the hype; don’t let your eyes deceive you. Printing money non-stop for a year (or longer, I don’t see him stopping any time soon) will have consequences.

- Charles W. Petredis

Disclosure: None.

Comments

[pitaking:]

I view the inflation/deflation issue as the one that will define 2009 but I'm firmly in the deflation camp for now. Until real estate finds a bottom, both commercial and residential, I don't think the Fed will win this fight.

Jan 12 03:30 PM

[jayz:]

Agreed, just like 6 months ago, if someone was talking about deflation, people would think he's crazy.

Jan 12 03:33 PM

[BK GUY:]

There will be inflation down the road. But will it be here in America? Or will it be abroad? Or here and abroad? This remains to be seen. Suppose all that money sitting in the banks is loaned out and invested, not in America, but in China, India, Brazil, etc. My point, in other words, is that while we can predict the creation of another bubble, we cannot predict where or how it will manifest.

Jan 12 03:35 PM

[Jason Rines...:]

What did the IB's do with the $250 B in Fed injected liquidity in February of 2008? Oh yeah, the lion share got dumped into oil... What will happen again at some point? Go long oil and natural gas. I am in Consumer Healthcare, seems there will be a great time to buy and hold big pharma for five years (after seeing Q1 earnings and Obama fiscal stimulus package). I am no day trader, the kind of continued volatility makes my stomach queasy.

Jan 12 03:39 PM

[patio:]

"When they decide to make this money available for use, we will see inflation problems that will make the price increases of this summer look very tame in comparison."
This money will be made available to who? Tapped out consumers, who don't want it anyway? Companies looking to expand? Nyet. I don't think we will see banks lending again without high credit rating, collaterall, etc.
No one seems to have any notion how this printed new capital finds its way into use, such that we have too much money chasing too few goods.
Japan didn't have inflation under the same relative circumstances.
I have yet to get even one idea how the "unfrozen" money gets into circulation.

Jan 12 04:25 PM

[Prudent Man...:]

One important realization of the current financial situation is the realization is that the stock market is not a leading indicator or has the "discounting" ability that the pundits like to sell. Those of us who have been around during the sixties and seventies already know that. Another realization is that the NYSE has been rigged to get nothing more than fees and commissions and that underwriting is, basically, unimportant. Face it, an good company can get financing almost anywhere. It is the large bureaucratic corporations that have the trouble they deserve.

The most profitable businesses today are privately owned and their managers are too busy growing then fooling around with dumb security analysts and bureaucrats. What sane manager would want their company to be publicly owned unless he or she is a sociopath and there are many of those running listed companies.

Jan 12 04:27 PM

[Top Gun:]

Fed added $250B to shore up capital. It is 3 year loan. Banks will need to raise the same to pay it back. Not inflationary, but only prevent asset deflation, not general price deflation.

Direct stimulus campaigns are inflationary.

Should have let the banks and asset prices crash, then the regular guy could afford them. Too bad.

Jan 12 05:10 PM

[levin70:]

No one will know when this shift will take place, excluding possibly the heads of all of the large banks.

I tend to disagree. Right now, all that cash given to banks is sitting at the FED. All you need to do is read the stat releases provided by the FED to figure that out. When you see the 700 billion in excess of required reserves start to drop, then you will know that the velocity of money will start increasing.

If nothing is done to drain the liquidity after this fact then that is probably a pretty good indication to start hiding in inflation fighting assets.

Just my two cents

Kind Regards

Jan 12 05:56 PM

[SW Richmond:]

You must perceive both the trap and the "solution" in order to see the path we are on.

The Trap: Falling tax revenues due to severe recession will bankrupt states and municipalities (debt default) and severely hamper US Federal spending. The US government deficit for 2009 is projected, WITHOUT ANY STIMULUS BILL, to be $1.2 Trillion, a near triple from 2008. Stimulus package is projected to be at least $800 Billion over two years, so for 2009 alone we are looking at $1.6 Trillion deficit. The Fed and the US government have committed or spent nearly $8 Trillion so far on this bailout. We have thus far funded (borrowed) practically none of this money. The states want a $Trillion or so. Mind-numbing amounts of money have to be borrowed and/or printed to pay for all of this; either that, or the debt must be defaulted. None of this is dollar-positive.

How will we pay for it? Any tax increase will kill what's left of the economy. Foreign lenders are already skeptical; China and Japan, our major Asian lenders, have sent clear signals that they do not intend to continue to lend us the usual amount of money. Japan has floated the idea of buying Treasuries if they are denominated in Yen. Our friends in the Middle East are our other major lenders, and they are in the process right now of accelerating their creation of a Gulf Coat Currency specifically to get off of the dollar, and then to begin pricing oil in GCC's. Their appetite for USD is obviously waning as well. None of this is dollar-positive.

The Fed has stick-saved the US economy numerous times and sometimes is forced to operate in ad hoc mode. They have begun quantitative easing (printing money) and have injected massive amounts of this new money into banks, which the banks have in turn deposited with the Fed as excess reserves. The Fed is paying the banks interest on these excess reserves. So many people say "the Fed can't make the banks lend" but that is nonsense. The Fed is being nice to the banks right now; that will change, and I will explain why and how.

So in a nutshell, the trap is this: falling revenue means swelling deficits, but more borrowing would need to be justified by higher interest rates and higher taxes, which would crush the already-mortally-wound... economy.

The "solution":
1. Currency debasement
2. Bank recapitalization
3. Fiscal stimulus


1. Currency debasement: To try to avoid "beggar-thy-neighbor", the major Western central banks are embarking on a massive and coordinated currency debasement. Mercantilist Asian nations are going along for now but remaining skeptical about new lending to the US. (Middle East nations are not willing to be paid in debased paper and are going to create their own currency to market their precious black gold.) The purpose of currency debasement is, of course, to render debt less onerous by paying it off with inflated currency.

1a. Trap capital by coordinating the debasement among cooperating Western central banks, leaving no safe destination for capital flight.

2. "Recapitalize" banks by injecting them with massive amounts of newly-printed money; the banks will (be allowed to) hang on to this cash bonanza until the remainder of the plan is in place.

3. Enact and begin a massive coordinated global fiscal stimulus plan. There is no point trying to force a massive reignition of lending until the fiscal stimulus is ready to go.

The major part of this effort will being only after the stimulus plans are enacted and money has actually begun to flow to projects, and after some large portion of funding has been put in place. At this point, banks will begin to feel pressure from the Fed and regulators to do something with their cash windfall. How? Simple: "we will guarantee a portion of your losses, make loans or pay interest on your reserves"; "make loans or we will make an example of one of you by revealing your true condition"; if you think authorities are above this kind of extortion, go back to grade school.

Additional regulatory measures could and probably will be used to force money into "productive" uses; the tax code provides a good vehicle for this.

Deflation, if allowed to persist, would destroy the machinery of state, namely tax collection. Anyone who believes that deflation will be allowed to persist ignores the simple fact that government runs on other people's money, that government is primarily interested in self-preservation, and that for that purpose, and that purpose alone, central banks are instituted. Deflation means that people can't afford to eat and that government must borrow money it can never pay back, from skeptical lenders, to feed them. Inflation is the path that preserves the existing political and social order.

I am not saying it will work because I don't believe it will. I am saying I believe that is the plan, and that the plan will be pursued to the bitter end. Odds of it ending in currency destruction are too high for my liking.

Jan 12 06:11 PM

[John Lounsbury:]

BK Guy - - -

You make a very good point. The investment banks have all disappeared or become commercial banks. Investment banks no longer exist and the commercial banks may step into the vacuum. So if the best return for the banks going forward is lending to Brazil, India, China or taking equity stakes in those countries, that's where the money will go and we will still have tight credit here. How could that be stopped? I don't think it can. It would be suicide to put tarriffs on money exports when we depend on foreign capital to buy our treasuries.

Jan 12 11:44 PM

[Steven Hansen:]

what an incredibly astute group of comments.

i would like to throw ZIRP into the economic gears. ZIRP is a double edged sword - it is inflationary / stimulus in the normal world but in our bizarro world it may act the opposite. it is creating a layer of very low interest rate paper. it is okay for the 30 / 90 day stuff. in 30 or 60 days if interest rates go up - they simply go up.

but if you have 30 year paper, and the interest rates go up - you have a piece of paper that literally loses its value (deflationary). the more and more long term paper that is sucked into the system with ZIRP, the more deflationary inflation becomes.

this is why i am afraid of ZIRP - it paints the economy into a corner.

Jan 13 02:03 AM

[Mr. L. Denny:]

Being a retiree with limited income, speculation isn't allowed and deflation of the dollar is unacceptable? Gold appears to be a possible safe haven for now! A strong fort in uncertain times.

I'm well satisfied. Comfortable and prepared! Debt free and a current passport!

Ahhhhh, GOLD!

Jan 16 02:11 AM