Inflation Or Deflation?

Includes: SH, VIXM, VIXY
by: Anacapa Strategy

Amid the relief over recent years concerning the apparent abatement of the financial crisis, most US economic and investment commentators have ignored the fact that the primary driver of the crisis, excessive debt, has not been addressed. The cards have been shuffled, and private debt has been transferred to public accounts, but this does not change the fact that there was a US debt overhang equal to over 3.5 times GDP as of the end of 2011. This was the economic problem facing the nation in 2008 - 2009, and it continues to be the problem today.

As we head into the third quarter, job growth is weakening and external demand shocks from Europe and China are affecting US exports. The dollar is strengthening despite record low interest rates, in part because of fears about the euro. Commodity markets have corrected sharply but a large segment of the public still apparently believes that investments in gold and silver can perform well in any environment. Many advisors have forecast a tremendous bull run in precious metals due to "money printing", and though they may be right in the long term, they have been decidedly wrong in the short term and are likely to continue being wrong in coming months.

There seems to be a central question posed at the present time whose answer dictates in large part how one should invest. Will easy monetary policies implemented by the Fed and other central bankers result in high levels of inflation, even hyperinflation, over the next few years? My answer to this is that money creation only causes inflation if 1) the money is distributed directly to consumers (for example by helicopter, as Mr. Bernanke once suggested), 2) banks readily obtain credit from the Fed through the discount window or other means and lend it out to their customers, or 3) the Fed engages in asset purchases, a process that prior to the financial crisis was generally limited to US Treasury bonds. Importantly, any money creation would have to be larger than the nominal decline in credit during a deflationary contraction in order for inflationary forces to take hold. The US Federal Reserve changed tactics during the financial crisis by purchasing a wide range of financial instruments, rather than just US Treasury bonds. The third option was therefore broadened, and the Fed used it to the tune of $4 trillion in disbursed bailouts financed by dollars created out of thin air, with total commitments reaching $7.8 trillion (Bloomberg News; Center for Media and Democracy).

However, this massive monetary expansion by the Fed only resulted in the effective plugging of a hole, for due to a collapse in asset values the amount of private credit decreased by almost as much as the Fed disbursed in newly created dollars. With $52 trillion in credit (debt) now in the US system (Federal Reserve), the question then becomes, will the Fed create enough credit to meaningfully negate a potential US asset market collapse? A 20% decline in US credit would require the Fed to deploy $10 trillion in new money to maintain equilibrium. However, that would only plug the hole; in order to create high inflation (and especially hyperinflation) in the midst of a deflationary collapse, the Fed would have to boost the money supply by far more. Doing so, in my opinion, would be untenable in the short term due to political pressure from leaders with a more conservative outlook who might object to the central bank acquiring approximately 20 - 25% of all US financial assets, especially at a time when constituents have elevated concern about perceived inequity in the system.

A more plausible scenario seems to be that in the event of an asset market meltdown later this year (excluding US Treasury bonds), the Fed and governmental leaders return to a gradually deployed combination of monetary programs and aggressive fiscal stimulus, in an approach similar to that seen in the previous crisis. As the programs expand on a cumulative basis, they will eventually outweigh the deflationary forces that should predominate in the short term. High inflation, and possibly hyperinflation, will indeed come, but only over the medium term - perhaps two to five years after the onset of a US financial market collapse. Investors will benefit over the short term by having exposure to short equity funds (such as SH), long volatility funds (such as VIXY and VIXM), and US Treasury bonds.

A quicker route to recovery would be to let asset prices and overall credit be marked down to levels that are sustainable by national income, but the Fed and US government leaders have shown that they prefer interventionist policies that will only result in a larger and more drawn out economic crisis.

Disclosure: I am long SH, VIXY, VIXM.