Inflation vs. Deflation: What Are Investors Facing?

Lately, there is lots of news about whether we are facing inflation or deflation. In the currency market, investors believe we are having hyperinflation, not just inflation. Thus, the US dollar keeps going down, and the long-term T-bonds yields have been going up and commodities prices are heading up. However, at the same time, the US production is low, the housing market is still not turning around, and the most important real wages are not going up. In this environment, it should be deflation, especially when consumers are not spending money.

Most economists think we are facing inflation soon because the US government has been printing a lot of money, by the billions. Based on economic theory, increasing money supply will increase inflation rate. The theory holds when consumers can access to easy money to buy things. As demand goes up, so do prices. However, this time is quite different. Consumers are deleveraging so they will not borrow more to buy things. When house prices were going up, consumers used their house equity as an ATM machine, taking money out to spend. Now, house prices are dropping so these consumers have no equity to borrow money. In fact, consumers are saving more now because of economic fear.

Furthermore, banks are tightening lending standards. Banks are lending but to the selected few. Therefore, even with all the money in the system, the inflation rate will remain low since consumers cannot access the money even if they need it. On the other hand, consumers are trying to lower their debt and to save more. Consumers are scare now and will think twice before spending. When companies are still laying off employees, consumers will not spend when they are worrying whether they will still have their jobs next month.

One important point is that the inflation theory is assuming the Federal Reserve (Fed) will leave the money in the system. Last time, the Fed left the money supply intact too long, thus creating the housing bubble. I do not think the Fed will make the same mistake twice. In other words, the Fed will start draining the money out of the system when the economy shows signs of recovery. This leads to my economic recovery shape – W. As the US economy starts to recover, it will drop back down again when the Fed starts to decrease the money supply or actually to take money out of the system. The Fed can only jump start the economy with the money supply but the economic recovery can only sustain with real economic growth, not from artificial money growth model. If the Fed withdraws the money timely, then inflation will remain low. Otherwise, we will see hyperinflation if the Fed leaves the money in the system too long – just like the tech and housing bubble.

What I worry about is spending by China. The Chinese government has been buying commodities from copper to oil. China wants to secure natural resources for its economic growth, especially when oil hit $145 dollars last year. In order to secure constant and reliable sources, the China government has been establishing reserves and signing contracts with commodity countries, like Russia and Australia. This is particularly true when the Chinese government wants to diversify away from US dollars. The Chinees government has lost some confidence in the way the US handles its monetary policy. Since the Chinese government holds more than $1 trillion US dollar in reserves, any dollar deprecation greatly affects its holding value. Nevertheless, as economists have argued: what else can the Chinese government buy if not US dollars? Obviously, China will not buy Euros since Europe is in even worse shape. Therefore, there is no other currency the Chinese government can put its reserves. This argument is true. Thus, the Chinese government has been buying up natural resources instead. In fact, the last figures show that the Chinese government has been buying fewer T-bonds. Of course, China's government cannot just unload its US dollars since it will collapse the dollar, but it can buy less and less.

Another way to diversify US dollar holdings is for the International Monetary Fund (IMF) to issue “special drawing rights”. The Chinese government has been arguing to use “special drawing rights” for a while now. I will discuss this issue in my next article.

Bottom line: We will not see inflation in the near future. The dollar will remain weak and the US economy may be stagnant for a while.

Investment strategies: Allocate less in the US stock market and more in emerging countries, commodities, especially natural gas; and even foreign currencies.

On a side issue: I am worrying whether the economies of the emerging countries are decoupling from the US. Thus, the rest of the world may be recovering while the US is still in a recession. In other words, the issue is whether the US will be just like Japan in its lost decades. Of course, others will argue that there is no such thing as decoupling from US consumers. If the US consumers do not spend, these exporting oriented emerging countries will not recover, period. However, I do not think the decoupling issue is that simple. I will attempt to address this issue in the future.

Comments

[damienhaas:]

I think inflation is a serious issue, even in the near term. First if investor rushed in to buy in commodities and drive up the commodities price, it would cause the price of goods to increases. Especially with the emerging market like China and India insatiable appetite for commodities. So we have the problem of Wage and Housing deflation and at the same time Commodities inflation.
Secondly, when the time come when the Federal Reserve must pull out the money supply, they might not willing to do it as we may be facing sub-par or zero growth for a long time.

Jun 19 07:48 AM

[jeandit75:]

Unless China is on someking of another planet, I don't see how they possibly decouple given their need for exports. Decoupling was a term invented once more to make people believe that China was gonna save us from depression. That's about it. A part from Utilities who really benefit from decoupling in their revenues, I don't see much other applications for this word except if someone wants to fool someone else in order to take advantage of their cupidity (well done Wall-Street).

Jun 19 08:18 AM

[The Geoffster:]

Any foreign manufacturer will tell you the U.S. market is the only game in town. This will change as China and India develop their internal markets but it is still years away so the U.S. consumer can enjoy another spending orgy before the dollar collapses and is replaced by something more stable. In the meantime, the FED will keep inflating the economy until the final bubble (treasuries) bursts.

Jun 19 09:05 AM

[Barking:]

James...how do you see gold doing in the above scenario?

Jun 19 11:18 AM

[carey_jim:]

Hyperinflation: An extremely high rate of inflation, often exceeding several hundred or several thousand percent, that causes a country's money to become practically worthless.

www.google.com/search?...=

Jun 19 12:34 PM

[daves1001:]

Yes, China is in a delicate position. Seems like their best strategy is to gradually wean themselves of investing in treasuries and hope that the dollar does not completely collapse before they have most of their eggs in other baskets.

Jun 19 12:58 PM

[James Kar:]

You are exactly correct. China needs to deal with the dollar situation very carefully. I think this is why China is gradually and slowly open up the capital market for RMB. Now, foreign firms can issue bonds in RMB for China expansion. Also, China starts to settle trade with its neighboring countries using RMB as well. This actually is more dangerous that people think. Because the changes are so slow and gradual, most people will not pay too much attention.


On Jun 19 12:58 PM daves1001 wrote:

> Yes, China is in a delicate position. Seems like their best strategy
> is to gradually wean themselves of investing in treasuries and hope
> that the dollar does not completely collapse before they have most
> of their eggs in other baskets.

Jun 19 01:15 PM

[James Kar:]

Hi Barking: I think the gold will keep going up gradually for 2 reasons: 1. as US dollar continue to fall, gold is an asset class has a negative correlation with the dollar. So, most investors will use gold to diversify the US dollar risk. 2. cultural demand - which has not been addressed enough. Both India and China consumers love to hold gold jewelry - not 12k or 14k, but in pure gold. As the middle class continues to grow, they have more money to buy gold jewelry, especially for Indians. They will buy gold when they have money and when the price starts to drop. So, I would say just the consumers in China and India can provide support in gold price so it will not drop too much from here. Of course, all bets are off when the global economy goes into deep recession, which I don't think it will happen.


On Jun 19 11:18 AM Barking wrote:

> James...how do you see gold doing in the above scenario?

Jun 19 01:23 PM

[OldLimey:]

" I do not think the Fed will make the same mistake twice."

I do. More precisely, I think you might be treating as a mistake something which in fact is an objective.

Jun 19 01:35 PM

[Dave Wrixon:]

Wait to the hording starts. I remember the 70s when people used to bulk buy sugar and other commodities because it was on the shelf. Actually, most of the time it was under the counter, but that is another story. People ended up with larders full of tin food they could not reasonably eat. Queuing became a national past-time, and I am talking about the UK, not Poland!

Jun 19 02:45 PM

[Dave Wrixon:]

They can decouple by advancing debt to other economies including their own.


On Jun 19 08:18 AM jeandit75 wrote:

> Unless China is on someking of another planet, I don't see how they
> possibly decouple given their need for exports. Decoupling was a
> term invented once more to make people believe that China was gonna
> save us from depression. That's about it. A part from Utilities who
> really benefit from decoupling in their revenues, I don't see much
> other applications for this word except if someone wants to fool
> someone else in order to take advantage of their cupidity (well done
> Wall-Street).

Jun 19 03:54 PM

[Dave Wrixon:]

This is the only game in town at the moment. It is like Liar Poker. Try to keep confidence high whilst simultaneously pulling the rug.


On Jun 19 12:58 PM daves1001 wrote:

> Yes, China is in a delicate position. Seems like their best strategy
> is to gradually wean themselves of investing in treasuries and hope
> that the dollar does not completely collapse before they have most
> of their eggs in other baskets.

Jun 19 03:56 PM

[ariosto:]

Given a gradual devaluation of the dollar, China seems to have decided to diversify by buying commodities while the price is
right and thus use up some of its dollar reserves. The Chinese
Government is in somewhat of a Catch 22: they cannot just
dump dollars without hurting the value of their reserves and they
cannot keep accumulating dollars. I believe they have come up
with a solution which, though not perfect, will answer their needs
without antagonizing the U.S.A.

Jun 19 05:12 PM

[wg:]

I think old Limey hits it right on the head when he says the goverment's inflating the money supply is "the objective." It s the way Obama, Rahm Emanual, Barney Frank, et. al. intend to bring their REAL vaunted "Change" to the American system--i.e. destroy the wealthy through inflation so as to "spread t he money around," and "level the playing field," as they have so often promised.
Yahoo!

Jun 19 06:44 PM

[KIT:]

China does not really float their currency against the USD its still fixed to it.

As the USD falls China goes with it making Chinas products even cheaper in countries other than the USA.

If China detached their currency from the USD because of inflation they kill profit from their largest customer.

1 billion people at $400 per year will not replace the American consumer.

Jun 19 11:32 PM

[Fighting Yoda:]

Rise in wages is the primary cause of inflation, money and credit play a role ultimately everything gets imputed into wages. 70% of the cost of production is wages, commodities play a rather small role in the rest of 30%. As wages go down, as everyone should be personally aware of this fact, inflation will be down - disinflation at best, there is good possibility of dreaded deflation.

Jun 19 11:33 PM

[Dave Wrixon:]

The Eurozone is the their largest customer.


On Jun 19 11:32 PM KIT wrote:

> China does not really float their currency against the USD its still
> fixed to it.
>
> As the USD falls China goes with it making Chinas products even cheaper
> in countries other than the USA.
>
> If China detached their currency from the USD because of inflation
> they kill profit from their largest customer.
>
> 1 billion people at $400 per year will not replace the American consumer.
>
>
>
>

Jun 20 12:07 PM

[carey_jim:]

Unfortunately, world history demonstrates that the future can neither be predicted reliably nor, even less, can it be controlled by private or public elites.

Human beings can't even define the terms of their conversations honestly. Instead, they speak with the vocabulary of various dogmas, from Catholicism and Islam to Marxism, Keynsianism and Austrian School economics.

Also, if we can't even predict the weather reliably, how can we predict the fluctuations of things that are far more complicated, such as the health and prosperity of companies and countries?

I agree that we have to try but we don't have to pretend that our predictions are more educated guesses forced on us by our financial needs.

Yelling and insulting each other is also inevitable but it usually makes everything worse.

Jun 20 01:51 PM

[carey_jim:]

That is:

I agree that we have to try but we don't have to pretend that our
> predictions are more THAN educated guesses forced on us by our financial
> needs.


On Jun 20 01:51 PM carey_jim wrote:

> Unfortunately, world history demonstrates that the future can neither
> be predicted reliably nor, even less, can it be controlled by private
> or public elites.
>
> Human beings can't even define the terms of their conversations honestly.
> Instead, they speak with the vocabulary of various dogmas, from Catholicism
> and Islam to Marxism, Keynsianism and Austrian School economics.
>
>
> Also, if we can't even predict the weather reliably, how can we predict
> the fluctuations of things that are far more complicated, such as
> the health and prosperity of companies and countries?
>
> I agree that we have to try but we don't have to pretend that our
> predictions are more educated guesses forced on us by our financial
> needs.
>
> Yelling and insulting each other is also inevitable but it usually
> makes everything worse.

Jun 20 01:52 PM

[Econ 101:]

The Chinese think in terms of years and decades while Americans think in terms of weeks and quarters.

The Chinese are willing to spend their dollars on commodities to get ride of them right now, and long term signing contracts in Yuans. Then 5 or 10 years from now they wont have dollar reserves and can float the Yuan against the dollar. Then the producing countries are pricing their commodities in dollars experience a sudden drop in income.

I disagree that 2 billion Chinesse at $400 a year wont provide a nice market, it will just be different from an American driven market. The average Chinese laborer wont p*ss away the equivilant of several hundred hours of his labor to buy a vehicle so he can live far from work and spend hours a day stuck in traffic. Their society and cities arent arranged that way and they dont have the excess resources to screw it up like America had.

The 21st century will be a struggle between the Chinese and the muslum world. I would bet on the Chinese. Incompetent American leaders from FDR to Carter to Clinton and both Bushes have destroyed the advantages we have enjoyed for over 2 centuries. BHO is just another in a long line of inept front men...

Jun 20 02:08 PM