Inflation Or Deflation - Which Are We Meant To Fear Right Now?

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by: Superinvestor Bulletin

Summary

Macro forecasting is forever a challenge and never more than today.

A strong case can be made that both inflation and deflation are significant risks.

We side with one of our favorite investors Francis Chou who believes that we need to worry about deflation first and inflation later.

No one ever said that investing is easy. If it was we would all have our own private jets. For macro investors seldom has there been a more confusing time to try and assess whether we should be more afraid of inflation or deflation.

You would think the risks should be clearly tilted towards one or the other but that isn't the case. The arguments for both cases are seemingly valid. Let's take a look at them.

The Case For Inflation

Source: TheBreakingTimes.com

Point #1 - Incredibly low interest rates for an incredibly long time

When it costs very little to borrow money, it is very tempting to take advantage of it. And when you get paid literally almost nothing for saving money there is no incentive to save it.

Lesser Interest rates will attract lesser savings. People tend to spend more when the interest rates are less. This creates more demand for goods and services which drives inflation.

Lesser Interest rates will encourage people to borrow more money. So, again people tend to spend more borrowed money when the interest rates are less. This creates more demand for goods and services which drives inflation

Well, we have never had interest rates as low as we do today.

Click to enlarge

Source: Money matter and more musings

Those low rates aren't just in the United States, they are everywhere. And they have been low on a historical basis for an incredibly long time.

Low interest rates are a primary driver of inflation so the current interest rate environment is the most conducive to inflation that we have ever experienced.

Point #2 - A slight change in the velocity of money would trigger it

The term velocity of money refers to how fast money transfers from one person to the next. The chart below shows how much like interest rates, velocity of money is at an all-time low.

Click to enlargeSource: Stlouisfed.org

There doesn't need to be much an increase in the velocity of money to make a significant difference to the rate of inflation. With the velocity of money being so low there is a lot of room for it to increase and still not be considered high.

Francis Chou points out in his latest investor letter that if the velocity of money were to simply return to its historical average it would take consumer price levels 25% higher than were they are today.

Carrying this logic one step further, Chou notes that with current levels of money-printing growing at a rate of 7.2% annualized we could see a potential increase in price levels of 50% should the velocity of money just high the historical average.

Point #3 - Ultimately there has to be a reckoning.

In explaining why Citibank bought such large quantities of subprime loans during the 2000-2006 US housing boom, Chuck Prince, Citibank's CEO, famously said that when the music is playing one has to keep dancing.

Well, all of this easy money policy has been going on for a very long time globally and the reality of the situation is that you can't "un-print" money. Ultimately there has to be consequences.

Picking exactly when is tricky. The fact that an enormous expansion of money supply will result in inflation eventually isn't.

The Case For Deflation

Source: Telegraph.co

Deflation happens when the supply of goods and services is greater than the demand for them. Not enough money chasing too few things.

With the world almost a decade into an unprecedented easy money policy deflation should be the last thing that we should be facing. Yet, there are several reasons why deflation remains a very real concern.

Point #1 - The locomotive is out of gas

There are some very sharp minds that think that China is no longer capable of dragging global economic growth along with it.

Click to enlarge

Source: Stan Druckenmiller - The Endgame Presentation

To keep up its high rates of growth China needs to keep ratcheting up bank debt levels. But China has already gone too far down that road.

Even following the financial crisis in 2008 China was able to grow at pretty high rates. However that growth was not from increases in demand but rather huge amounts of government spending on items that weren't needed and won't be repeated. Think ghost cities and empty highways.

Take China's unsustainable growth out of the equation and the demand for everything globally is going to be impacted.

Point #2 - We have too much capacity

Click to enlarge

Source: Fairfax Financial 2015 Shareholder Letter

Very low interest rates and a big belief in the China led commodity super-cycle led to an unprecedented build-out of commodity production. That might have been fine if China could continue growing at 10% per year forever, but that turns out not to be the case.

The result has been too much supply chasing slowing demand growth. The table above shows what the result has been to the prices of major commodities. It is going to take a while for demand to absorb all of this extra capacity.

Point #3 - We've already thrown the kitchen sink at this problem

For years now global GDP growth rates have been sluggish. That isn't great, but what is worse is that these growth rates have been sluggish despite unprecedented efforts to kick start economic activity.

The logical question then becomes "what happens when we stop trying so hard to stimulate growth"? At some point Central Bankers may have to step aside and let the world take the medicine that is required to deleverage to normal levels.

When/if that happens deflation is going to be the obvious result.

What Is An Investor Meant To Do?

In the annual shareholder letter from Francis Chou that we linked to earlier Chou summed up the current environment very well. We are inclined to agree with him.

Here is what he wrote:

The current situation reminds me of a story about an exchange between Winston Churchill and MP Bessie Braddock:

At one time when Churchill was drunk, Bessie Braddock yelled at him, "Winston, you are drunk, and what's more, you are disgustingly drunk."

Churchill retorted, "My dear, you are ugly, and what's more, you are disgustingly ugly. But tomorrow I shall be sober and you will still be disgustingly ugly."

That's how I feel about deflation and inflation (eventual consequences of printing too much money).

Chou's point being that deflation may be the risk in the near term, but the reality is that we will eventually feel the results of all of that easy money policy. When that happens we are all going to wish we took Stan Druckenmiller's warning seriously and had some gold (NYSEARCA:GLD) in our portfolio.

Note: We have an upcoming article in which we profile a few options for profiting from the near term risk of deflation. Make sure to click the follow option at the top of this article so that you don't miss it.

Thanks for reading.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.