Inflation or Deflation? Both Are Right and Wrong at the Same Time

Observing the ongoing cyber discussion whether we currently live in an inflationary or deflationary environment I hope I can add a little more than my 2 trillion cents.

• Yes, we are experiencing a lot of inflation these days!
• Yes, we are experiencing a lot of deflation these days!
• No, there is no inflation these days!
• No, there is no deflation these days!

Let these four arguments sink in for a second before you continue reading or - god beware - you surf to another blog for orientation in these messy times.
All 4 opinions are both right and wrong at the same time. Here's why:

It mostly depends on the interpretation of these 2 nine-letter words (the third bad one is "recession") that have been slowly descending from discussions among economists - 99% of whom did not correctly forecast the current economic mess - into heated talks on the tables around me in my favorite Viennese lunch joint with less and less customers every week - that raised its prices by 5.4% within a year.

True Eurozone Inflation Now at 7.4%

As a general principle I prefer to follow the Austrian school of economics that defines inflation as the expansion of money supply - which has been exploding on a global scale while the economy contracts in almost all countries that publish these figures correctly.

GRAPH: Nominal M3 growth in the Eurozone. Remembering an old rule of thumb from the German Bundesbank, undoubtedly the best inflation fighters in the second half of the 20th century, economists there subtracted GDP growth from M3 growth to arrive at the true rate of inflation. If I follow this rule with the European Central Bank's (ECB) M3 data series - find a handy overview of key Eurozone figures here - I arrive at a true inflation rate of 7.4% as of April 2009. Chart courtesy of ECB.

The Federal Reserve stopped publishing money supply M3 figures - the broadest monetary aggregate - well before M3 ran into the 2-digit area. Luckily shadowstats.com has filled the void, calculating M3 with an error margin of 0.3%.

GRAPH: Even M2 (read the comments of this post) is now running at annual rates solidly in the 2-digit percentage growth area despite a contracting US economy. Chart courtesy of Fed St. Louis

The other attempt to define inflation is to derive it from rising prices for goods and services. Taking two recent statistics from the EU's statistical office Eurostat, I discovered a big discrepancy: While the flash estimate for annual inflation for May arrived at 0% (pdf) on May 29, Eurostat had released alarming figures on living conditions in the EU, headlining "One third of the EU population could not afford an unexpected expenditure in 2007" that also said that 7% of EU inhabitants were already in arrears on their utility bills.

Looking at my own energy bill I notice that natural gas for heating my (badly insulated) residence has become about 25% more expensive despite natural gas retreating from $13 to $3 on futures markets since its historical highs in 2007. Looking at the other bill of the day I see my chimney sweeper has raised his fees by some 18% in the last 6 months.

I would not exactly call this deflation. Keep in mind that consumer price indices have been changed by statistics offices in order to keep index-bound pensions and with it nations' expenses low.

But, YES, there is a lot of deflation in this world, as all owners of stocks or real estate have sadly found out in the past 2 years. Take the market index chart of your choice or compare your house/flat price with that from a year ago and there is hardly an exception to the newly rediscovered concept of asset price deflation.
Asset price deflation is a direct result of commercial banks' policies. As we have regressed from a savers society into a debtors society on a worldwide scale asset prices are heavily influenced by banks' willingness to lend money for purchases of asset papers (stocks) and real estate or other things.

In one short sentence: If banks don't lend to buyers, your theoretical net worth development will turn south.

As an additional note I want to remind you that we have not evolved very much since medieval times. As the majority of the population was then paying a part of their earnings to the count or king it nowadays has the same plight towards banks. Buying a house or whatever else on credit does not make you an owner at an instant, but only puts you in the debtor's position until you have paid off your loan to the last cent.

As a general rule for reading economic indicators do not fall for the trap of slowing relative (percentage) growth which is now widely used by bankrupt governments to paint a rosy picture. A slowdown in growth of an indicator does not mean it has reversed its development. This trick may work with overworked and underpaid financial journalists, but should not succeed with prudent investors who are willing to walk the extra mile of knowledge to protect their savings.

I finish this post with another rhetorical question: Which creditor/saver would mind price deflation? Or would you feel worse because your petrol bill recedes to levels last seen in the second millennium AD, when crude oil traded at less than $15 a barrel? It is time we proceed again and get mankind out of the credit trap that has led us into the biggest economic disaster in history! And now everybody please stop punching your discussion counterparty. You are both right and wrong at the same time.

Comments

[Mad Hedge Fund Trader]

the bond market certainly sees inflation. Just another update on my core short in long dated US Treasury bonds, the TBT, which hit a new high for the year of $60, up 72% from my initial call (www.madhedgefundtrader...). The nine to eleven year note auction went off OK, despite its enormous size. What drove the yield on the ten year to a seven month high of 3.99%, the 30 year to 4.67%, and herded buyers into the TBT was the May US budget deficit of $190 billion, an all time record, despite massive inflows of income tax revenues. The news also gave the dollar a steroid shot and sent equities on a 200 point intraday swoon. If high rates and $70 crude don’t go away, they are going to kill the stock market. Everyone is holding their breath for the 30 Treasury bond auction tomorrow. The time to pay the piper is coming, and his rates are going up.

2009 Jun 10 04:36 PM

[Prudent Man CFA]

If one thinks this bond curve is showing inflation now, just wait. The short end of the curve is being held down because fixed income investors have slid down the curve. It is under priced and demand can change in a heart beat - and will.

It isn't what China wants to do. It is what they must do as they are operating at a deficit. They can rigged their books, like the U.S., just so long. Remember Enron?

Nobody seems to be interested in the Boomers bombing social security and medicare. BHO wants to get us all into Nationalized Health Care to cover over the Ponzi that has been going on for fifty years by Republicans and Democrats. Although I deplore BHO's fascists tactics I can understand the hand he "assumed", not inherited as he likes to claim ad nauseum, as every president has in the past few decades. Has the buck finally stopped here? I am surprised that the rubber band of debt could get stretched as far as it has before snapping.

Fiscal responsibility, private and public, is not a choice.

2009 Jun 10 05:14 PM

[Jasper M]

Not a bad article.
I think it would have been more instructive to look father out, to reason out, not what is the state of things now, but what they will three years out.

2009 Jun 10 07:22 PM

[cameroni]

You have my complete agreement Prudent Investor that we are indeed experiencing both inflation and deflation. And while it seems to defy logic it actually makes perfect sense given our nations past credit excess, and the credit crisis as it has unnaturally coincided and is now colliding with a long-run commodity bull cycle.

This combination has produced a very risky economic cocktail that not only has the potential to deprive you of wealth through asset losses but to simultaneously drive your expenses higher. It will cheat you of gains you made through savings while destroying what you have paid for and built up over decades.

We are all the poorer for what is taking place and the two variable sets point us down conflicting paths. Most people are having a lot of difficulty with this idea. While on the one hand it is advisable to stock up on fuels, foods, imported goods, precious metals etc to offset inflation risks (spend without getting ahead really), on the other we would be better served to retire debt quickly and save as the specter of rising interest rates creates a different risk set.

We should also normally anticipate real estate prices to increase but they will not, confusing us as to the real outcome and trajectory of the economy.

Spend and Save at the same time with the risk of falling behind despite your best efforts! It could make you psychotic!

My own strategy is to forgo real estate purchases and investment. These are not investments at a time like this. They are financial risks if not downright liabilities. With two exceptions. Rural properties (small towns) and productive farm land.

The second part of my strategy is to take advantage of, and stock up on consumables that I fully anticipate will become out of reach luxuries in a few years. I note that we are already in an environment where we (North Americans) are already drawing down our consumer inventories. This is a topic unto itself. but if you will just note the Baltic Dry Index as a rough guide we know that inbound shipments are off.

That means in very specific terms that as existing consumer goods inventories dry up over the next 2 years in conjunction with a mountain of worthless devalued dollars entering the system we will start to experience the first signs of a very nasty and devastating inflationary spike. Look out. This is the future and there is no changing the outcome now. It is a freight-train.

But you will argue, production will ramp up and offset those negative affects. I agree to a certain extent but we need to keep in mind too that it is human nature to save in times of crisis. Without the return of the big spenders and the return of credit flows there will be no consumer spending rebound. In other words, there will be shortages going forward and over short time periods as demand outstrips supply we will see inflationary spikes quite unlike anything we have ever experienced before.

And here is something else nobody will want to hear. I am convinced that reverse ETF's will eventually be proven to have been one of the biggest "sucker plays" ever invented. While drawing in huge swaths of the investment world intent on capitalizing on much anticipated market declines they will instead drain away investors savings and along with it hope as no real crash ever materializes.

Our inflation will not be what we are expecting as ordinary. Our deflation will continue to defy logic. I fully expect that housing prices will drop (substantially) while costs of retaining homes will rise. As well, stocks should generally continue their climb despite negative contrary indications. And it is primarily commodities in conjunction with declining dollar values and inflation risks that will (and are) driving markets up.

I could blither all day. Enough said though.

2009 Jun 10 08:32 PM

[Fighting Yoda]

You can't be both right about inflation or deflation - referring to disinflation or the other evil cousin stagflation?

It is Trillion $ debate, opinions divided and battle lines drawn, lot of experts on either side of the debate:
Inflation: Peter Schiff, Marc Faber, Art Laffer (a new OpEd in the Journal today), lot of Wall Street
Deflation: Fed (it claims to be fighting deflation), Gary Shilling, Paul Krugman, Mike Shedlock/Mish, and me.

It is all about expectations – ‘anchoring of inflation’ – if consumers believe in it they will get inflation if they believe in deflation they will get deflation.

2009 Jun 11 01:19 AM

[Jasper M]

Yoda,
Just to play devil's advocate,
In the midst of a mild deflation, those industries where the government is trying to keep prices up, especially by direct payments, could see a relative rise in prices (=more money supply In That Industry), while general prices drop (=less money supply in general).

Remember that, if deflation fosters suspicion of credit, that allows a certain decoupling of markets supported by fiat credit, and thus we could have, in essence, more than a single money supply: The Feds can Declare there is X amount of credit available to prop up, say, real estate, but if No One outside of real estate will respect the resulting valuations (=can't get a loan vs. your house), then that has become a separate money supply, which can rise independent of general drop.

In the current case, for example, we might see inflated prices in financial assets ('cause Goldman gets the money first), cars (got to keep those crappy shingles going), and alternative energy (faith over science), while prices of pretty much everything else drop.

Personally, I expect deflation to win, and win big, utterly wiping out all attempts to inflate, in pretty much Every sector. But I enjoy the exercise of examining other possibilities.

2009 Jun 11 02:31 AM

[Fighting Yoda]

Jasper M:
Whenever there is excess liquidity - easy cheap money - it will find its way into the system and certain asset classes may rise. We saw this last time around with housing and commodities. Everyone has given up on housing now, commodities, stocks are being targetted. One way or other there will be distortions and it will end badly. But general deflation is more likely with loss of velocity of money, liquidity trap.


On Jun 11 02:31 AM Jasper M wrote:

> Yoda,
> Just to play devil's advocate,
> In the midst of a mild deflation, those industries where the government
> is trying to keep prices up, especially by direct payments, could
> see a relative rise in prices (=more money supply In That Industry),
> while general prices drop (=less money supply in general).
>
> Remember that, if deflation fosters suspicion of credit, that allows
> a certain decoupling of markets supported by fiat credit, and thus
> we could have, in essence, more than a single money supply: The Feds
> can Declare there is X amount of credit available to prop up, say,
> real estate, but if No One outside of real estate will respect the
> resulting valuations (=can't get a loan vs. your house), then that
> has become a separate money supply, which can rise independent of
> general drop.
>
> In the current case, for example, we might see inflated prices in
> financial assets ('cause Goldman gets the money first), cars (got
> to keep those crappy shingles going), and alternative energy (faith
> over science), while prices of pretty much everything else drop.
>
>
> Personally, I expect deflation to win, and win big, utterly wiping
> out all attempts to inflate, in pretty much Every sector. But I enjoy
> the exercise of examining other possibilities.

2009 Jun 11 10:45 AM

[Jasper M]

Yoda,
"Whenever there is excess liquidity - easy cheap money - it will find its way into the system and certain asset classes may rise. We saw this last time around with housing and commodities."

It will find it's way not the system IF those outside the "chosen sectors" are optimistic enough to accept it.
Fear is a wonderful thing. If government price supports on homes kept those prices up, while everything else dropped, A LOT, do you suppose ANYone would be able to get a home equity loan? No, the market would recognize that the underlying asset was overvalued, and refuse to accept the collateral at the inflated face value.
(come to think of it, the banks are in this position already!)

And I agree with you re general deflation. Just discussing theoretical disconnects.

2009 Jun 11 01:23 PM