With Mr. Ben S. Bernanke at the Fed, I can say with conviction that the probability of deflation is zero. Further, with policymakers of the same mindset, I can say with conviction that deflation probability is zero even after Mr. Bernanke steps down as the chairman.
Deflation will only happen when there is a complete collapse of the existing financial system. I am of the opinion that such a scenario is not likely in the foreseeable future.
This article discusses the reasons for believing that there will be no deflation in the foreseeable future and in the next 5-10 years. On the contrary, we might witness moderately high to very high inflation during this period.
How can Mr. Bernanke and Co. prevent deflation?
According to Mr. Bernanke, it is pretty simple under a fiat money system. Below is an excerpt from Mr. Bernanke's speech in 2002 - "Deflation: Making Sure "It" Doesn't Happen Here."
The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject's oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.
What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
Further, Mr. Bernanke states that:
Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly.
These statements prove the conviction of central bankers to prevent asset market deflation and deflation in general.
In Mr. Bernanke's own words, he has the printing press to prevent deflation. Therefore, even if money velocity remains at record lows and banks are not lending, inflation can be created by the taking the stance of printing unlimited amount of dollars.
QE3 program is partially tending towards that direction. Unlimited bond and mortgage-backed securities purchases will flood the system with liquidity, with the program not being a sterilized one like the ECB's OMT operation. As witnessed after the announcement of the program, the dollar declined against all hard assets and major currencies.
I had also discussed in one of my earlier articles in financial repression that I believe that dollar devaluation, financial repression and near-zero interest rates for an extended period have just one objective - to create inflation.
Near-zero interest rates have done no good for the real economy and to the already leveraged consumers.
The movement in crude oil prices is a good example of how inflation can be created by currency devaluation in a relatively weak economic scenario. Crude was trading below $80 at the time of peak global economic activity before the crisis.
Currently, crude is at much higher levels in times of global manufacturing recession. Of course, we need to discount the geopolitical factors. However, even with that discounted, energy prices have created inflation due to currency devaluation.
One of the best examples of the point I am trying to make here is the price of gold in dollar and in currencies making up the dollar index.
Over the last ten years, gold has appreciated by 450% in terms of the dollar. During the same period, gold has appreciated by only 303% in terms of the currencies making up the dollar index [Euro (57.6%), Japanese Yen (13.6%), UK Pound (11.9%), Canadian Dollar (9.1%), Swedish Krona (4.2%) and Swiss Franc (3.6%)].
Clearly, asset price inflation is significantly impacted by the currency. In order to create enough inflation, Mr. Bernanke and Co. can resort to meaningful currency devaluation.
As I mentioned in the beginning, deflation is a possibility only in the case of a collapse in the existing financial system. I don't want to sound very scary, but it is entirely possible in the long-term.
The current solutions are temporary and do not solve the long-term structural problems in the economy and the financial system.
Further, the government debt has peaked by historical standards, and the next decade and beyond should witness a flurry of debt restructuring, defaults, financial repression, inflation and hyperinflation.
Hyperinflation and the destruction of currencies is nothing new: the world has witnessed 29 cases of hyperinflation in the last 100-years.
I am of the opinion that we are headed for another phase of government debt defaults and hyperinflation. Policymakers with the mindset of Mr. Bernanke would not really mind high inflation or hyperinflation, as it liquidates government debt.
In the current scenario, there is no way that the US government can repay the massive debt. Further, more debt will be piled on over the next 10-years ($10 trillion, according to the CBO).
Invariably, governments in an inescapable debt trap will default through massive inflation. In general, that is followed by a period of deflation. Therefore, both inflationists and deflationists might be right in the end. The common masses are just on the wrong side.
There is no one investment strategy or investment suggestion that would work in the current economic and financial scenario. The best strategy is to be diversified globally with greater exposure to hard assets such as gold, silver, crude and few other industrial commodities.
Also, equities in developed and emerging markets will do well with real interest rates expected to remain negative in the coming period of high inflation. Once we survive the phase of ugly inflation, we can discuss deflation.