Inflation: Is This the Real Danger?

"Man’s got to know his limitations.” (Dirty Harry)

The massive bear market rally of the last two weeks has resurrected fears of inflation but I’m not sure inflation will be a problem—at least not in 2009. Nevertheless, a lot of people in the financial press and blogosphere are sounding the alarms prematurely and I’m not sure this is helpful to traders and investors. For me, the issue is about timing rather than strategy because both the inflationary and deflationary camps could be right.

There’s no question about it—when the Fed increases the monetary base a lot of money is ultimately going to flood the economy and the new money will compete for goods and services driving prices up. But this is also highly dependent on behavior patterns of the past. How certain are we that capital will flow into the same investments that thrived in inflationary periods of the past as we emerge from a very severe financial catastrophe? I think we’re going to see less spending for a while as we return back to health and the savings rate will increase. This is a generational shift, too, and the boomers who spent their money freely will be too busy licking their wounds and protecting what they have left. And 30:1 leverage is done, so let’s see how Wall Street generates the same profits of the past.

We also have to consider some of the deflationary elements that are causing so much distress in this current economic environment—mainly job losses, declining wages, and plunging home prices (the plunge continues). This are not purely monetary issues which is why the Fed is having such a hard time right now. I know that many inflation experts don’t consider falling home prices a deflationary phenomena because it’s not a monetary issue but a supply and demand problem—prices fall because demand declines. This is a limited view because it defines deflation solely on the contraction of the money supply and credit. That’s grossly oversimplifying a complex situation.

I think most economist will I agree that the very nature of a price drop is a deflationary event but it seems that people are also in the business of redefining economic terminology. In other words, if money didn’t drive the price down then it’s not deflation. Hmm. Tell that to the dude who lost all the equity in his home or saw his salary reduced by 10% this year. The terminology is very dangerous and almost Taliban-like in its fundamentalism. Some also think the CPI is a joke, but those people probably never shop for their own food or put gas in their car to notice the shifts in price. Trust me, the average homo sapien knows the cost of things. Right now we have fallen prices and fallen wages. I don’t see inflation yet.

During the last 12 months, we have also seen an unbelievable price reversal in energy prices. Just keep in mind that OPEC had to cut oil production to bring prices back up to the $50 range, putting in danger recovery efforts in many parts of the world. Oil, too, will take time to return to pre-crisis levels. Furthermore, Japan, which is the world’s second largest economic power is heading for deflation and the epicenter of that crisis is the retail sector. Many believe the U.S. is headed in the same direction and the latest data is not encouraging.

It’s amazing how some people keep ignoring the obvious. People just don’t respect the threat of deflation. We have record level unemployment claims, contracting GDP, and the housing sector is in the gutter. That’s not enough evidence? In an uncertain world we have to consider every threat—we have to hope for the best but be prepared for the worst. I just can’t overstate the importance of not going along with herd in times like this. Yes, eventually the new money will flow into cheap stocks and commodities and we’re going to have to deal with inflation but that time is not now.

Comments

[cannedpawn8:]

We may not have price increases, but I don't see any price decreases in food, gas, hot water heaters(had to hve new one), fertilizer for lawn, tools, home handiman stuff, my nat gas company locked in its cutomerpass-thru at $7.8 per dekatherm..I could go on.

Mar 29 08:30 AM

[cannedpawn8:]

As a follow-up, then why is the Fed buying TIPS on the curve? Is it because they are afraid they will become too costly for them when inflation goes full bore...?

Mar 29 08:32 AM

[prudentinve...:]

Apart from gasoline prices, which have always been volatile, I have not seen a price decline in anything I buy. The sharp drop in commodity prices has not been passed through to the end buyer of products made from these commodities.

Perhaps I am missing something, so please support your deflation arguments by posting a table of products that consumers purchase that have declined in price. If you are talking about home prices, please post a twenty-year curve and tell us if they have "declined", except relative to an absurd and short-lived bubble.

Mar 29 09:36 AM

[PastTense:]

My biggest monthly expense is health insurance. A couple weeks ago I got a notice rates would be increasing 8% while co-pays would be increasing 50% (office visit from $30 to $45)
Last week my electric utility sent out a notice of proposed rate increase. They are asking for a permanent 16% increase (and requesting an 8% temporary increase) (they have an energy cost pass-through in addition).

So lots of us are seeing inflationary price increases.

Mar 29 09:41 AM

[socrateazz:]

Interesting: According to the definitions inflation ( the increase in money supply) is taking place. If that is used as the definition then we have not gone to deflation at all. The real problems within the economy are balances of supply and demand of large amounts of goods. Where prices were good recently, there are an excess of supplies and prices have plumented. Where prices have been poor recently, there are looming shortages and pressure exists to hold those prices down. When shortages become great enough, prices will soar to meet that demand. Any efforts to hold prices up (like housing) or hold prices down (like rice) will eventually cause a strong opposite reaction. Governments are focusing in on myths like global warming and a whole host enviornmentally related beliefs when reality is different from their beliefs. I see it in my profession; Colleges teach beliefs as truth. Most believe because the colleges teach fact. And Fact is truth. Then reality shows what people have been taught was not fact. A new hypothesis comes up and becomes the fact! Most truths are situational. Under assumed normal situations, the rules are facts. The human problem is that people take their own or others beliefs and try to make facts out of them. When they ignore reallity when supporting their view, essentually they are wrong!

Mar 29 10:55 AM

[MattZN:]

Deflation, like inflation, can get out of control. There is nothing inherently more stable about deflation. The Japanese found that out the hard way. We have no real track record on being able to solidly manage ourselves in a deflationary environment. On the other-hand, our nation has a lot of experience managing Inflationary environments. We know we can deal with inflation. Given the choice, I'd rather deal with inflation where we can actually see the light at the end of the tunnel verses deflation where we can't.

Everything is relative. Having a lot of money that grows more slowly is roughly equivalent to having a little money that grows more quickly. Anyone who has a lot of money knows this. Deflation will not magically make our quality of life better.

Frankly, I think an inflationary environment is better-suited to our nature then a deflationary one. At least so far as growth is concerned, capitalism seems to operate at its highest efficiency with a small amount of well managed inflation, and as long as our population continues to grow that is where we need to be on the curve.

-Matt

Mar 29 12:28 PM

[paxjds:]

Get real Max, inflation is in some markets right now. Three years ago Irish Creame $19 a bottle, $24 now. A 12 pack of Ginger Ale was $3.33, now $4. Sirloin Steak was $4.99/#, now is $8.99/#. Gasoline is down, but OPEC is in process of correcting, and gasoline is heading up again. That will take the above items Higher. Auto's are down due to fear in the marketplace and job security. That will change quickly when employers start to hire again. Housing is down, but when that bottom is reached, housing will start to rise slowly to match the mixture of inflation, demand, and rising wages.

Mar 29 01:50 PM

[Jimbo:]

I am with PrudentInvestor on this one. I keep insisting that what we are experiencing is STAGFLATION. Employment,house prices, and liquidity are down. But my haircuts have gone up more than 50% in the last three years. The electric utility just got a 25% increase and the water utility has just imposed an increase that I have not yet quantified. Real estate taxes, in spite of price declines, have NOT declined. Gasoline is on the way back up.Fresh fruit and vegetable prices do fluctuate but all other processed and packaged items in the grocery have either gone up or the container is downsized. Bananas, for example, seem to have gone from 39 cents a pound and have now "stabilized" at 69 cents a pound. Goods and services of all kinds, from newspapers to cable TV, UPS has dramatically increased the price I pay to receive fresh roasted coffee delivered to me. And on and on.

Mar 29 04:07 PM

[Neal Vander...:]

People just keep looking over the hill expecting the worst to be over with ignoring the lessons of the great depression or even Japan for that matter. The government has sat idly by while masses of people are loosing all of their belongings. Oh wait they did come in afterwords after all had jumped off the cliff without para shoots but perhaps it wasn't to save anyone just an opportunity for the them in the chaos. One would think it wouldn't happen to a powerful nation but once again history repeats itself when given a chance to repeat scenarios that obviously lead to bad outcomes. I guess all those years of study to make one a politician or financial expert they didn't learn 1 lesson from history in acquiring their degree. Perhaps the lesson for them is to create more control over people and not to make society better with new circumstances. Any reasonable and educated leader would be able to see the crisis in advance but in the news leading to all reports signaled that there was no crisis looming or even a recession. Very sad to see such poor leadership and decisions that effect masses of people that don't have the same educations of our leaders.

Mar 29 04:43 PM

[Mad Hedge F...:]

The printing presses are already seeing it. All of the high grade paper used by the US Treasury to print money is bought by one firm, Crane & Co., which has been in the same family for seven generations. Last year the Feds printed 38 million banknotes worth $639 million. Although they have seen the recession cause the velocity of money to decline, recent reflationary efforts have spurred a big increase in demand for paper for $100 dollar bills. The US first issued paper money in 1861 to finance the Civil War, and Crane has been supplying them since 1879. The average life of a dollar bill is 21 months. Who said no one was doing well in this recession? M1, or notes and coins in circulation, is already exploding. Is this a warning of an imminent jump in inflation?

Mar 29 08:22 PM

[tclwrap:]

capitalisthero,

I disagree with your statement:

"inflation is only bad for debtors..."

In reality, deflation is bad for debtors... This is because what you already owe is difficult to come by when wages drop 10%. The wage drops are due to price drops, which is caused by weaker demand.

If you have accumulated savings, deflation is good.



On Mar 29 04:37 AM capitalisthero.com wrote:

> Will someone explain to me why deflation is bad? In deflation, the
> purchasing power of my wages is increased. The purchasing power
> of my nest egg is increased. Food, water, shelter, and medicine
> is cheaper because of deflation.
>
> As far as I can tell, inflation is only bad for debtors because their
> real interest rate is increased. I guess that sucks for the U.S.
> government since it's the biggest debtor the world has ever known.
>
>
> Deflation = good. Inflation = bad. Buy commodities as a hedge against
> inflation. Divest yourself of dollars; they will become very abundant
> very soon.
>
> Check out my original articles at captialisthero.com

Mar 29 10:50 PM

[Dave Wrixon:]

Not sure about deflation being a good thing, but the discussion is irrelevant. We are not getting deflation over an extended period. The US in particular is headed for hyperinflation, and you are the government debt angle is crucial. Yes, of course they are not going to want to pay interest rates, and yes the do want their debts deflated and reduced. And no the don't give a damn about the dollar. And yes, they will be totally ineffectual in controlling inflation for the above reasons. Does Bernanke understand any of this. I very much doubt it!


On Mar 29 04:37 AM capitalisthero.com wrote:

> Will someone explain to me why deflation is bad? In deflation, the
> purchasing power of my wages is increased. The purchasing power
> of my nest egg is increased. Food, water, shelter, and medicine
> is cheaper because of deflation.
>
> As far as I can tell, inflation is only bad for debtors because their
> real interest rate is increased. I guess that sucks for the U.S.
> government since it's the biggest debtor the world has ever known.
>
>
> Deflation = good. Inflation = bad. Buy commodities as a hedge against
> inflation. Divest yourself of dollars; they will become very abundant
> very soon.
>
> Check out my original articles at captialisthero.com

Mar 30 01:03 AM

[Dave Wrixon:]

Hell it makes no difference. All they will do is keep sticking extra zeros on the end. Most of the extra money is just balance sheet stuff. There will also be a accelerated shift to more electronic purchasing reducing the need for physical money. Rather than being good for them this could speed their demise.


On Mar 29 08:22 PM Mad Hedge Fund Trader wrote:

> The printing presses are already seeing it. All of the high grade
> paper used by the US Treasury to print money is bought by one firm,
> Crane & Co., which has been in the same family for seven generations.
> Last year the Feds printed 38 million banknotes worth $639 million.
> Although they have seen the recession cause the velocity of money
> to decline, recent reflationary efforts have spurred a big increase
> in demand for paper for $100 dollar bills. The US first issued paper
> money in 1861 to finance the Civil War, and Crane has been supplying
> them since 1879. The average life of a dollar bill is 21 months.
> Who said no one was doing well in this recession? M1, or notes and
> coins in circulation, is already exploding. Is this a warning of
> an imminent jump in inflation?

Mar 30 01:05 AM

[dybydx:]

deflation is as bad as inflation or slightly worse.

long term effects of money supply is neutral, but prices are sticky and market adjustments take time to reflect the difference in price level.

most economists and central agree that it is ideal to have a low level of inflation. the definition of "low" varies. this is usually 1 to 3% developed nations and higher in developing nations.

Mar 30 10:03 AM