Inflation vs. Deflation Debate: Both Sides Are Persuasive

I have written before that the inflation vs. deflation bet is likely the Call of the Decade.

That topic is becoming hot. I have had several exchanges in the last few days about the inflation vs. deflation outlook for the economy. Some have pointed to Barry Ritholtz’s post at Big Picture indicating that deflation currently has the upper hand. Dave Rosenberg also pointed to the same theme today.

On the other hand, Warren Buffett wrote an op-ed in the New York Times warning of the risks of USD devaluation and debasement should the US government continue on its current trajectory of deficit spending, which would lead to inflation for US residents.

I will repeat what I said to everyone that I discussed this topic with.

When I read the analysis, both camps are persuasive. Both camps are populated with some very smart investors (who wants to bet against Warren Buffett?)

Let the model decide
It is becoming evident that the future will be dominated by either inflation/hyper-inflation/USD devaluation, or deflation, but little in between. In this case, I would prefer to allow a trend following model do its work and tell me which way the wind is blowing (see an explanation of the model here).

Comments

[Jasper M:]

". . . I would prefer to allow a trend following model do its work . . . "

Spoken like a true scientist.
But there is a problem with that - trend following models are notoriously poor at detecting changes in the larger trend in a timely manner.
I would prefer to allow a trend-Predictive model to do its work. As, in fact, I am.

Aug 20 03:34 PM

[Alan Young:]

Buffet is sitting on piles of fixed-income investments and cash. Obviously he's planned well for deflation. Naturally, inflation is the only thing he has to fear. It suits him to warn against it, but that doesn't mean he's betting on it.

Aug 20 03:48 PM

[The Geoffster:]

Dollar devaluation is a given. How else can we service the debt? The politicians are incapable of reducing spending. Their livelihoods depend on appropriations. Higher tax rates are also a given but the economy will have to improve significantly for higher taxes to make much of a difference and the middle class will have to ante up despite what the President says because that's who makes most of the income. Put me in the inflation camp.

Aug 20 05:18 PM

[Ricard:]

I don't think this is much of a call.

The fact is, extremes on either end are destructive. We've already killed the goose on our end (credit bubble), so perhaps what everyone will agree upon is that we will experience credit deflation. Whether or not this translates to actual deflation or rampant inflation (or something in between) is really up to the Fed to decide at this point.

If we experience deflation, business will suffer, but folks will certainly be persuaded to fix their balance sheets. If we experience inflation, more than likely Bernanke will attempt to control its impact. Whether or not this destroys the credibility of the dollar depends upon the shape of other economies around the globe. If they're in worse shape than us, we may likely come out ahead, even if all of us on absolute terms suffer during the 'recovery'.

I'm no longer fully convinced that deflation is as harmful as the 'enlightened opinion' make it out to be. Bernanke has all but proved that if we were to enter a deflationary spiral, the Fed can print enough $$$ to jump start inflation. What loses in a deflationary outcome are leveraged balance sheets, and this group of businesses (probably toxic financials) more than likely is lobbying like mad in Washington.

As far as how to play this is concerned, TIPS are deflation-protected, and indexed to inflation. IMHO, they are the obvious defensive choice.

Aug 20 08:28 PM

[Ricard:]

All models can be manipulated...


On Aug 20 03:34 PM Jasper M wrote:

> ". . . I would prefer to allow a trend following model do its work
> . . . "
>
> Spoken like a true scientist.
> But there is a problem with that - trend following models are notoriously
> poor at detecting changes in the larger trend in a timely manner.
>
> I would prefer to allow a trend-Predictive model to do its work.
> As, in fact, I am.

Aug 20 08:29 PM

[E Nuff Sed:]

In a deflationary environment, unemployment will spike because wages are sticky and it is a lot easier for businesses to lay off a fraction of the workforce than give the entire workplace a hair cut. Some employers will do both.
This in turn feeds more deflation as purchasing power is eroded and businesses will have to lower prices to attract the few remaining customers who have money and so on - a deflationary spiral builds up - which can crush the prices of assets.
If you have no debt and lots of liquid cash or gold you are king - other wise watch out.

Aug 20 09:39 PM

[Joe Shareho...:]

deflation wins hand-down. The only thing that will inflate is commodities because of a sick and dying dollar - and grocery store follow. Housing, durables, etc all deflate.

Aug 20 09:59 PM

[anomium:]

Due to the level of debt (public and private), deflation cannot be allowed to take hold. Bernanke has indicated long ago that he will prevent deflation by any means necessary.

The behavior of the stock market indicates that it is being used as a tool of reflation by the Fed. The next shoe to drop will be soaring commodities prices and long term interest rates. At that point, it will become clear whether inflation or deflation will have the ultimate victory.

If the economy goes into another tailspin when oil shoots back past $100 / barrel, we are in for a protracted, decade plus contraction of Japan-style stagnation, deflation and falling demand.

If the economy does not resume contracting at that point, it will look more like the 1970s, except with resource scarcity being irreversible and physical rather than political, and without the option for escape from inflation running away into hyperinflation (economy is too fragile to cause an intentional crash with interest rate hikes).

If the central banks do a perfect job, the best that can be hoped for is to split the difference and muddle through in a condition of en.wikipedia.org/wiki/....

Aug 24 11:47 AM