Is Inflation a Fact… Or Just an Opinion? Part I

We need to seriously re-assess the threat of inflation.

Anytime a particular point of view reaches mass hysteria, you HAVE to be willing to look at it from a different perspective. Today, inflationary fears are beginning to reach that point. The words “Weimar” and “Zimbabwe” are thrown around regularly. Hyperinflation is becoming a serious point of discussion even amongst people who rarely focus on financial markets.

Gold investment schemes (based on inflationary fears) are all over the radio and TV today. G. Gordon Liddy, a man who masterminded Nixon’s break-in of the Watergate hotel, can be seen on television crumpling up dollar bills and telling investors to “buy gold.”

When a crook of Liddy’s caliber appears as a spokesperson warning you not to trust the government and to diversify away from the dollar… then you know things are beginning to get out of control. It would be one thing if only a small handful or professional investors were warning about this (as was the case with the housing collapse and financial crisis). But inflation concerns are now common amongst even non-investors.

Whenever everyone begins to think the same thing, you HAVE to question it, regardless of whether or not you personally believe it too. You never, and I repeat, NEVER make money by investing alongside the mob. So if the mob is screaming “inflation,” you have to be willing to re-consider the facts. It’s quite possible the mob is wrong (it usually is).

Please understand, I write this with the utmost humility. I myself have brayed about inflation in previous months. But this current inflation mania is beyond anything I could have predicted. For certain, all fiat currencies fail. And at some point inflation will take hold and the world’s central banks will need to impose some kind of backing (most likely gold) to the world’s reserve currency.

However, this may be several years down the road. It could potentially even be a decade down the road. No one really knows when it will happen. But one thing I DO know is that if I hear people talking about inflation in coffee shops (just as they were talking about Tech stocks in 1998 or housing prices in 2005) then it’s quite possible they’re wrong (at least in terms of the urgency of the matter).

The primary belief driving the inflation trade is the idea that the Fed’s money printing will damage the dollar irrevocably. The below chart showing the US monetary base is often cited by inflationists (myself included) as evidence for this.

As you can see, the Fed has more than doubled the US monetary base in the last year, pumping some $900 billion into the financial system. Inflationists are also quick to point out that the monetary base doesn’t account for the $13 trillion the Fed (and Treasury) have put into the system via various lending windows and off balance sheet arrangements. These lending/ printing efforts are seen as further evidence that the US is heading for massive inflation in the near future.

Aside from the current money printing, there are also looming deficit and liabilities issues to be dealt with. All told the US has $11+ trillion in debt on its balance sheet. When you throw in future Medicare and Social Security expenses, our future liabilities explode to $65 trillion. Inflationists believe that the Fed will have to inflate these debts away, because the public would not stand for a default or rolling back of these programs. This last point is quite arguable however, since the hyperinflation used to inflate these debts away wouldn’t exactly thrill voters either.

These, as far as I’ve seen, are the central arguments for coming inflation. Drawing from these ideas, inflationists believe that the dollar will soon roll over pushing commodities (especially gold) through the roof.

In July 2008, when the dollar index bottomed at 72, the Fed had committed less than $500 billion in bailout funds/ intervention (mainly to Bear Stearns). Since then, the Fed has:

• Spent $400 billion on Fannie/ Freddie (Sept ’08).

• Taken over insurance company AIG (Sept ’08) for $85 billion.

• Doled out $25 billion for the auto makers (Sept ’08)

• Kicked off the $700 billion TARP Program (Oct ’08)

• Backstopped $540 billion in money market funds (Oct ’08)

• Backed up to $280 billion of Citigroup’s liabilities (Oct ’08).

• Given $40 billion more to AIG (Nov ’08)

• Backed up $140 billion of Bank of America’s liabilities (Jan ’09)

• Spent another $787 billion in the Stimulus Plan (Jan ’09)

• Announced plans to buy $500 billion worth of mortgages (Jan ’09)

• Announced plans to buy $300 billion of Treasuries (Mar ’09)

• Announced plans to buy $750 billion more of mortgages (Mar ’09)

This is a staggering, and I mean STAGGERING amount of money being thrown around. And yet, the dollar today is actually a full 11% HIGHER than it was in July 2008. In fact, it’s trading higher than it was BEFORE Bear Stearns went under!!!

This is beyond bizarre. The world is currently operating under a fiat currency discipline: meaning no major currency is backed by anything of real value. Under this discipline, the Fed (and central banks around the world) are pumping TRILLIONS into the world’s financial system… and yet commodities and other traditional inflation hedges have FAILED to best their July 2008 highs (a time when Central Banks had yet to commit substantial funds to battling the crisis).

They’ve also failed to best their July 2008 highs despite the fact that EVERYONE (even the coffee shop crowd) is worried about inflation. To be blunt, either the market has lost any ability to discount the future what-so-ever, or the inflation story is not actually as simple as inflationists have claimed (money printing= inflation). I’m inclined to believe the latter, as indeed, nothing is ever quite what it seems or as simple as people make out.

Indeed, the dollar chart and commodity charts paint a very different picture from the common opinion that “the Feds is printing dollars ad infinitum and inflation is exploding higher.” Clearly, the market is trying to tell us something different.

Good Investing!

>>> Go to Part II

Comments

[Jack Reacher:]

Liddy took the fall for his boss. It was an honorable move. It was a soldier charging the machine gun, so his colonel would not have to.

I wonder if you realize how shallow and ignorant you sounded calling him a "crook".

jr

Jul 01 05:55 PM

[Neil459:]

Don't know Liddy, don't know if he is a crook. But listen to one of these commercials and he and the rest sure sound like crooks.

Jul 01 06:01 PM

[Fighting Yoda:]

Inflation is a monetary phenomena - but the problem is how you measure money. Is it monetary base only or monetary base + credit. The money multiplier - velocity of money.

In a credit driven economy like US - credit matters a lot more than monetary base - all the money can be printed but if it does not reach the consumers through credit or wages (rise) - the money will sit in bank vaults. We have all the evidence of credit shrinking - that is loss of money - leads to deflation. The resulting deflation is leading to fall in prices - commodity prices are a glaring example.

Inflation expectations (future inflation fears) are measured by TIPS - showing low inflation expectations. So either we will have outright deflation or dis-inflation(low inflation) - none of the data currently points to inflation.

btw- gold has never tracked inflation.

Jul 01 06:30 PM

[woollyB:]

Good column. I would suggest that the dollar's performance isn't "beyond bizarre." The biggest debt bubble the world has ever seen is largely dollar-denominated. Thus, despite the Fed doing its best to destroy the dollar, credit is contracting even faster and the remaining dollars gain value. In other words, people are selling anything and everything to get dollars to service debt. Bob Prechter was/is right. Deflation is firmly in control.

Jul 01 06:40 PM

[Mad Hedge F...:]

So far, it's just an illusion. I spent the evening with Dr. Janet Yellen, the president of the Federal Reserve Bank of San Francisco. She thinks that thanks to the government’s tax cuts and spending programs, we will be out of the recession by the end of this year. After massive inventory liquidation, the auto industry in particular is poised for a rebound. Financial markets are now in better condition than we imagined possible six months ago. However, the pace of the recovery will be frustratingly slow, and it could take several years to return to full employment. Since the majority of the Fed board members feel that inflation will be stuck at 2% for years to come, deflation presents a greater risk than inflation. We are not by any means out of the woods yet. Rising energy prices and interest rates are a potential drag on the economy. Commercial real estate is at the top of her worry list, as falling rents and capital values could create a downward spiral, further impairing the banks. China’s wishes for an alternate reserve currency are impractical. Answering questions as only a UC Berkeley professor can, she further confirmed my belief that we are looking at an “L” shaped recovery at best (see www.madhedgefundtrader... and www.madhedgefundtrader... . However, she did pour some cold water on my idea that the TBT has further to run. “Inflation running up to untoward levels doesn’t make any sense,” she averred.

Jul 01 06:44 PM

[Swashbuckler:]

Liddy is a convicted felon who has served time. For some unfathomable reason, many people choose to call our fine upstanding convicted felons crooks.

Jul 01 06:52 PM

[Craig W:]

The author offers anecdotal evidence that “the masses” are talking about inflation/devaluation. Maybe true, maybe not.

Let’s explore the possibility that the anecdotal evidence is true and that the majority of Americans are in fact concerned about inflation/hyperinflation. I would think that if lots of people are sold on the hyperinflation argument, they would be borrowing as much as they could and purchasing hard assets (kind of like what happened in the real estate market, except driven by fear instead of greed/stupidity). Instead we observe that the savings rate of dollars in going up and the demand and supply of personal credit is going down. There is no doubt that the government is desperately trying to kick-start inflation, and they may be succeeding, but so far, the pesky savers have not been cooperating.

This conflict seems to suggest one or more of several possibilities. Here are a few of them:

1) The authors assertion is not true, the majority of “regular” people are not talking about inflation . . . they have no idea what is going on.
2) The author’s observation is representative of the majority of people: the fear of inflation in the near term is real and widespread, but the folks are behaving contrary to their own self interest . . . maybe they are concerned, but the real point of recognition hasn’t hit yet.
3) The business community and/or government and/or press are talking up inflation in an attempt to push people into riskier assets so banks and other corporations can raise capital via secondary offerings (presumably because they are worried about solvency).

Jul 01 07:05 PM

[PastTense:]

Lots of us believe that there won't be significant inflation for a while; but then there be very major problems with inflation. But lots of us are no good at market timing. Thus the best policy for lots of us is to make anti-inflation investments now--rather than trying to time the period of time when inflation starts to really take off.

Jul 01 07:17 PM

[JohnAl:]

Day after day the debate rages. Deflation or inflation?

Clearly, the credit bubble is still deflating. Clearly, the monetary base has expanded. But expansion of the monetary base isn't enough to fuel price inflation. Price inflation requires credit expansion, and that isn't happening. Lenders aren't lending and borrowers aren't borrowing.

Has the game changed? I think so, at least temporarily, Last fall was ugly and what has happened since has been even uglier. Lenders and borrows are scared. Money holders are scared. The result? Stagnation. Everybody waits to see what is going to happen.

And what IS going to happen? Eventually, inflation will win out. It has to. Politicians won't stop spending (until the printing press is taken away.) Stagnation may go on for years though. Like the 30's. The longer it goes on the more likely we'll see hyperinflation in the end because the Fed won't want to stop the spree once it starts. Unless there's a political (i.e. free market) revolution - which IS a possibility.

Today's strategy... wait, and watch. Watch carefully.

Jul 01 07:38 PM

[The Geoffster:]

Good article and comments. The Fed is primarily focused on avoiding a deflationary spiral. There is still a lot of debt to write off and TARP money is sitting in the FED earning interest instead of multiplying its way through the economy. The Fed may be able to trim its balance sheet and sop up excess liquidty when the time comes but it can't do anything about the national debt except monetize it. When inflation comes, everyone will wish they had been hedging in 2009-2010.

Jul 01 08:39 PM

[Bruxley:]

The markets are globally hurt and given that the currency is on a flat system the valuations, relative to eachother, aren't being reflected. Further, fundentals are being ignored because of a great desire for the pain to stop and accepting the fundementals at face value is painful right now.

The pressure doesn't stop buidling though. Just because it is being acknowledged doesn't mean it is somehow it's not real or will just go away. It will manifest. At some point the piper always gets paid and as always the longer he is avoided, the higher the price.

Nothing magical or mystical has taken place. The effects will be the same as they always have been and always will be.

Stand by, make your inflationary postions NOW before the crowd and get ready for the same tough road as the late 70s. The same ingredients always make the same the same dish.

Jul 02 12:30 AM

[DWStein:]

From where I sit (about 12:30 am Thurs morning) I see the 10year treasury at 3.54% and the 10yr TIP at 1.80%.

In very unscientific terms, that's the market baking in about 1.75% inflation over the next 10 years. Even accounting for the fed buying treasuries, the market does not seem to be overly concerned about the prospect for inflation. So, while the talking heads might be in a frenzy, market participants seem, at least for the moment, to be more sanguine.

I think, however, you have to take the treat of future inflation seriously. The big problem, as I see it, is the similar threat of deflation. In fact, I think wresting with these two seemingly binary eventualities is the key issue of the day.

Summers' analysis of the market has merit. Given all the money printing, why isn't gold back over 1,000. Perhaps they are not printing enough?! Are they already 'pushing on a string'?

Don't forget that money is not just currency. 'Money-ness' is a market phenomenon - a human phenomenon - that may prove very difficult to resurrect by force (like it was in Japan). The Fed can't make developers buy multi-family deals at a 3% cap in Florida because condo's are selling at $2500/SFT. The Fed can't make housewives in Japan decide to dabble in currency speculation. Once the school teacher turned condo-flipper get's caught long 5 houses, the government may not be able to recreate that wealth via fiat.

So while the market may not be in panic mode at the moment, we have to think about both inflation and deflation. What to do?

As speculators, our job is to figure out where the next panic will be. I'm sure I don't need to remind anyone where credit spreads were at the end of the last cycle. To be really clear, market complacency is not a good predictor of future smooth sailing. As the author above is trying to point out, it is generally a very good contra-indicator.

Back to square one: how do I allocate precious capital in a world where both inflation AND deflation could be a problem?

Stay long VOL?????

Jul 02 01:26 AM

[Ryu Mei Co:]

Even thought the world is "flat", the complex global economy we see today is not the simple 1 + 1 = 2 anymore. The inflationary equation has became more sophisticated and complex, more variables and conditions to consider, and the math has became more challenging than Einstein's theory of relativity.

Inflation does not equal to a simple money printing variable anymore than we can say 1+1 = 2. We have to look beyond the US, and we have to look at more variables.

For example, Japan, Russia, China, Singapore, Europe, Canada, and UK are printing massive amount of money as well, and even though the US is printing more money, we cannot deny the fact that their currencies has a direct affect to the US dollar.

And moreover, the market had just lost so much "value" thru the credit crisis, the printed money was simply replacing what was once lost.

However, if the US continues to inject massive amount of money into the market, continues to increase Fed budget deficit and ignore sign of inflationary pressure, then we will have a currency crisis.

Jul 02 03:41 AM

[Steven Hansen:]

let me see, early last year nobody saw anything wrong.

today we talk about what we just went through and deflation - who would have talked about deflation a year ago?

the economy does not operate with a fine tipping point. it is broad and very hard to move. but once the motion begins it is very hard to stop.

inflation will happen. the government and the fed is screwing with the economy. something will turn out to be the last straw which changes the balance. the economy will inflate rapidly.

it will happen because their will be too much liquidity, too much spending, too much debt - all to try to get the economy to reset back to the good ole days. by the time they realize they are at the tipping point, it is too late,

when inflation will happen is the question, not if it will happen.

Jul 02 03:55 AM

[Neil459:]

Good ideas, but in the end the Fed is a political organization. I know I worked there. Granted there are good people there, but I guarantee you no one will be putting forward ideas that are not politically acceptable.

On Jul 01 06:44 PM Mad Hedge Fund Trader wrote:
> So far, it's just an illusion. I spent the evening with Dr. Janet
> Yellen, the president of the Federal Reserve Bank of San Francisco.

Jul 02 07:45 AM

[TeresaE:]

Maybe for investors, the "inflation fear" is currently unfounded.

But in the real world of ZERO savings and paycheck-to-paycheck living, inflation is already here and it hurts.

My utilities have raised rates (with the blessing of Michigan-higher sales tax revenue) FOUR times in the past 3 years. They are currently back at the regulatory agency asking for more.

We were just notified that our health insurance for our employees is going up AGAIN. This time by nearly 33%. The funniest part of this is that now my employees "hourly wage" will appear to improve, when in actuality my employees will take pay cuts in line with their 20% that they pay for coverage. So, less take home pay and higher expenses.

Food. I cannot believe how small packages are becoming with increases in prices.

Inflation for the necessities is already here folks. The only question is when it will hit across the board.

And with China buying everything in the world from technology, to coal, to gold and even food, how ANYONE can claim "inflation" isn't/won't happen is living in the same world where I was told that there was NO underlying nationwide recession coming.

Even when I saw it happening.

Experts don't live in the real world, nor do they do the jobs in the industries in which they tout themselves as experts.

Jul 02 10:30 AM

[Dirk McCoy:]

Bearing in mind that price levels don't move in concert, there are a lot of moving parts here, but the biggest to consider:

1. Huge destruction in credit and credit velocity- last number I saw was $20 Trillion, making the $13 Trillion seem woefully inadequate- real estate and equities have born the brunt of initial deflationary pressure;

2. Deflationary pressure on labor- China, India, Eastern Europe and productivity tools have augmented labor supplies by enormous amounts, creating deflationary pressures on labor- to the extent price controls or price fiction operate, this translates to higher unemployment, especially in high labor cost markets like California;

3. Technological progress- Solar panels are nearing $1/W, down from over $300/W 25 years ago. Biotech has increased ag yields (ask dairy farmers who are killing cows and dumping milk). And internet and telepresence technologies are offering the ability to achieve superior productivity at home and overseas;

4. Acceptance of democracy, private property rights, and free trade- The masses are becoming better educated- consider that Mr. Obama ultimately had to run on a platform of keeping taxes low (don't forget his line about taxes on the wealthiest being lower than under Clinton), leaving NAFTA alone, and allowing private companies to earn profits. There is growing unease with his healthcare and cap/trade initiatives, and the GM/Chrysler debacles have exposed a raw nerve in the country over union pay. This nerve grow rawer as unemployment continues to rise and state budgets continue to suffer.

The biggest problem I see is the price controls that are keeping prices from dropping in labor. This is creating state budgetary disasters and pushing operations outside the country. Even product development and administrative functions are moving out of the country. To the extent this is to take advantage of foreign growth markets, this is a good thing, but ultimately a market equilibrium will need to be reached- either via labor inflation in foreign countries, labor deflation here, or exchange rate adjustments.

I still believe gold and oil would recover before labor and associated goods (including equities), but I just don't buy the hyperinflation given all the alternatives to $6/gallon gasoline (like work from home, more coal, solar), and as has been discussed, the US dollar is no longer based on gold.

Our fiat currency is backed by the full faith and credit of our government behind it. The US is relatively stable, productive, and able to tax its citizens (and withhold benefits). To the extent that US citizens realize that productivity- which acts to counter inflation- is key to future living standards, those dollars will retain value. But we saw 30% dollar devaluation during the Bush years while global and US economic activity was strong- we probably need to see it again.

Jul 02 01:25 PM

[Obamitall:]

But not if they work for ACORN!


On Jul 01 06:52 PM Swashbuckler wrote:

> Liddy is a convicted felon who has served time. For some unfathomable
> reason, many people choose to call our fine upstanding convicted
> felons crooks.

Jul 04 07:16 AM